The UK's CFC rules and the freedom of establishment: Cadbury Schweppes plc and its IFSC subsidiaries ± tax avoidance or tax mitigation?

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1 The UK's CFC rules and the freedom of establishment: Cadbury Schweppes plc and its IFSC subsidiaries ± tax avoidance or tax mitigation? ec TAX REVIEW 2007±1 Tom O'Shea, Lecturer in Tax Law, Centre for Commercial Law Studies, Queen Mary, University of London 1 The judgment of the ECJ in the Cadbury Schweppes 2 case demonstrates some of the difficulties Member States have in designing their tax systems in an internal market context. What is `tax avoidance' from one Member State's perspective is simply an exercise of the freedoms from another state's point of view. 3 The ECJ is thus faced with the unenviable task of balancing the rights of Member States to protect their tax base from artificial cross-border transactions with the rights of Community nationals wishing to establish themselves in the Member State of their choice, through the exercise of a fundamental freedom provided for in the EC Treaty, to take advantage of the more favourable tax rules in that host Member State. The first part of this article examines the Special Commissioners' Decision in Cadbury Schweppes which made the reference to the ECJ. The second part outlines the Opinion of Advocate-General Leger. Section 3 details the judgment of the ECJ, the fourth offers some analysis of the case, and the final part concludes with some final thoughts The author welcomes comments: t.o'shea@qmul.ac.uk and wishes to thank Philip Baker QC, Frans Vanistendael, Richard Lyal, Anton Hume, Christiana HJI-Panayi, David Simpson, David Evans, Eric Tomsett, Grahame Turner, and a number of other people who took the time to respond. This article has benefited from some of those comments. Cadbury Schweppes plc, Cadbury Schweppes Overseas Ltd. v Commissioners of Inland Revenue, C-196/04 judgment of the ECJ (Grand Chamber) of 12 September 2006, available online at (last visited 21 September 2006). The UK Revenue has recognized this problem in their Guidance Manuals on CFC Rules saying that `one man's ``tax avoidance'' is another man's tax efficiency!' See HMRC Guidance Manuals INTM ± `Controlled Foreign Companies: exemptions ± the motive test'. The literature on the Cadbury Schweppes case is immense and growing. The following is a selection of materials written in English: Case Comment: `Cadbury Schweppes result', Accountancy 2006, vol. 138, no. 1355, p. 112; Case Comment: `UK law criticised in Cadbury Schweppes result', Accountancy 2006, vol. 137, no. 1354, p. 108; G. Murphy, `Genuine tax planning OK in Europe? A review of two recent ECJ cases', Accountancy Irl. 2006, vol. 38, no. 1, pp. 76±78; T. Lyons, `What will the ECJ decide tomorrow?', BTR 2006, vol. 4, pp. 399±407; Case Comment: `Advocate General delivers opinion in Cadbury Schweppes case', Comp. Law. 2006, vol. 27, no. 8, pp. 244±245; M. Cripps, `Cadbury Schweppes case', CSR 2006, vol. 30, no. 3, p. 24; N. Vinther, `Tax motives are legal motives ± the borderline between the use and abuse of the freedom of establishment with reference to the Cadbury Schweppes case', Euro. Tax. 2006, vol. 46, no. 8, pp. 383±386; R. Fontana, `The uncertain future of CFC regimes in the Member States of the European Union: Part 2', Euro. Tax. 2006, vol. 46, no. 7, pp. 317±334; R. Aitken, `Sweet victory for Cadbury Schweppes?', IT Rep. 2006, June, pp. 1±3; N. Smith, `CFC rules in the EU', IT Rep. 2006, March, pp. 6±12; M. Desborough-Hurst, `Advocate General says controlled foreign companies rules can be compatible with EU law', IT Rev. 2006, vol. 17, no. 6, pp. 102±103; E. Tomsett, `AG rules on CFC legislation in Cadbury Schweppes case', Intertax 2006, vol. 34, nos. 8/9, pp. 448±449; F. Carr, `Compatibility of controlled foreign companies legislation with EU treaties (ECJ)', Ir. TR 2006, vol. 19, no. 4, pp. 39±41; A. Rainer, `ECJ hears case concerning CFC legislation', Intertax 2006, vol. 34, no. 3, pp. 171±172; Case Comment: `Freedom of establishment', TPTN 2004, vol. 25, no. 20, p. 159; D. Williams, `Do the CFC rules breach the EU Treaty?', Taxline 2004, vol. 7, pp. 8±9; J. Muller, `Cadbury Schweppes case: a review', TPIEUF 2004, vol. 6, no. 7, pp. 14±17; Case Comment: `Controlled foreign companies', Norton Rose PLC 2004, vol. 15, no. 7, pp. 85±86; A. Craig, `EC tax scene: challenge to UK CFC legislation referred to ECJ', Intertax 2004, vol. 32, no. 10, p. 530; J. Schonfeld, `The Cadbury Schweppes case: are the days of the United Kingdom's CFC legislation numbered?', Euro. Tax. 2004, vol. 44, no. 10, pp. 441±452; Case Comment: `Freedom of establishment', TPTN 2005, vol. 26, no. 4, p. 32a; M. Wathelet, `Free movement of capital', Tax J. 2005, 774, pp. 4±6; M. Helminen, `Is there a future for CFC regimes in the EU?', Intertax 2005, vol. 33, no. 3, pp. 117±123; D. Hill, `The CFC regime: restricting EU fundamental freedoms?', FITAR 2005, April, pp. 1±5; P. Elliot, Case Comment: `(Order for reference to the Court of Justice) SpC [2004] STC (SCD) 342', EC Tax Review 2005, vol. 14, no. 2, pp. 108± 109; Case Comment: `Controlled foreign companies', TPTN 2006, vol. 27, no. 6, p. 48a; Case Comment: `Advocate-General delivers opinion in the Cadbury Schweppes case', Taxline 2006, vol. 6, pp. 13±14; Case Comment: `Less common ground', Tax. 2006, vol. 156, no. 4043, p. 439; Case Comment: `Winners all round', Tax. 2006, vol. 157, no. 4057, pp. 152±153; S. Whitehead, `What's your motive?', Tax. 2006, vol. 157, no. 4076, pp. 682±684; A. Hume, `Advocate General's Opinion in Cadbury Schweppes', TPITP 2006, vol. 7, no. 5, p. 32; G. Brannan, `Cadbury Schweppes ECJ tax appeal: AG's Opinion: CFC rules conditionally upheld', TPIR 2006, vol. 33, no. 5, p. 19; Case Comment: `AG's Cadbury Schweppes decision a victory for common sense?', TPIEUF 2006, vol. 8, no. 5, p. 20; Case Comment: `Advocate General's Opinion in Case C-196/04: EC TAX REVIEW 2007/1 13

2 1. The Special Commissioners' decision The Special Commissioners' `decision' 5 is of interest because unlike their decision in Marks and Spencer, 6 on this occasion, the Special Commissioners, given the uncertainty concerning the compatibility of CFC rules with Community law, decided to refer the matter to the ECJ for guidance rather than delivering a decision based on their understanding of Community law. Consequently, the issue concerned the compatibility of the UK's CFC rules with Community law ± more specifically, with Arts. 43, 49 and 56 of the EC Treaty, or the freedom of establishment, the freedom to provide services and the free movement of capital respectively. The decision set out a clear set of agreed facts 7 ± some of which are worth repeating here in order to understand the background to the UK's CFC rules which only apply in limited circumstances because of the possibility of benefiting from certain exclusions or `safe harbours'. Understanding these safe harbours is important because of the significance that one such exclusion ± the `motive test' ± plays in the UK's CFC scheme Facts 8 Cadbury Schweppes plc, a UK incorporated and resident company established two indirect 100 per cent wholly-owned subsidiaries in Ireland in the IFSC in order to benefit from a special 10 per cent rate of taxation. The Irish indirect subsidiaries were established mainly to carry out treasury functions ± to raise finance and to provide that finance to other members of the Cadbury Schweppes' group of companies around the world. At the hearing, it was explained that the Irish subsidiary was established for a number of reasons: (a) to replace a structure involving a Jersey company; (b) to remedy a Canadian tax problem for certain preference shareholders of Cadbury Schweppes plc; (c) to avoid UK Treasury Consents for certain overseas lending; (d) to benefit from the Parent-Subsidiary Directive and reduce the withholding taxes paid on intragroup dividends. These purposes could have been equally achieved if the Irish subsidiary had been incorporated and resident in the UK. The second indirect subsidiary was established in Ireland to avoid the application of UK foreign exchange regulations on certain US dollar transactions carried out by the subsidiary. By establishing the Irish subsidiaries in the IFSC, the profits arising from their intra-group lending treasury activities in Ireland would not be taxed in the UK and would benefit from a very favourable 10 per cent tax regime. Normally, UK resident companies that establish subsidiaries outside the UK are not taxed on the profits of those subsidiaries until such profits are repatriated to the UK. When the UK's CFC rules apply, however, the income of the foreign subsidiary is attributed to the UK parent (although that income has not been received by the UK parent company) and is taxed with credit for the foreign tax paid by the subsidiary. The UK CFC rules apply when the subsidiary that is resident outside the UK is subject to a `lower level of taxation', meaning that the tax paid by the foreign subsidiary is less than three-quarters of the amount of UK tax that would be paid on the profits of the subsidiary as computed for UK tax purposes Exclusions The UK's CFC rules were subject to a number of important exclusions: (i) an `acceptable distribution policy'; 10 Cont. Cadbury Schweppes plc, Cadbury Schweppes Overseas Limited vs. Commissioners of Inland Revenue, European Court of Justice', TPIEUF 2006, vol. 8, no. 5, pp. 19±20; A. Dolton, `Cadbury Schweppes Plc v CIR', Tax J. 2006, 836, p. 3; R. Wilkinson, `Controlled foreign companies', Tax J. 2006, 837, pp. 17±20; C. Morgan, `FII Group Litigation and Cadbury Schweppes', Tax J. 2006, 838, pp. 7±8; H. Foster, `Does the ECJ still keep the taxman away?', Tax J. 2006, 840, pp. 9±12; C. Morgan, `Landmark decision in the Cadbury Schweppes case', Tax J. 2006, 854, pp. 7±8; W. Dodwell, `Cadbury Schweppes: the future of CFC legislation', Tax A. 2006, July, p. 27; Case Comment: `Controlled foreign companies', Norton Rose PLC 2006, vol. 17, no. 5, pp. 94±95; C. Morgan, `CFC rules: legality under EU law', Offshore Red 2006, vol. 11, no. 5, p. 110; Case Comment: `ECJ rules against UK anti-tax avoidance rules', NLJ 2006, vol. 156, no. 7240, p. 1379; S. Shapiro, `Cadbury victory helps captives', LLID 2006, September, p. 3; H. Foster, `ECJ ruling favours taxpayer', Lawyer 2006, vol. 20, no. 37, p. 8; D. Smyth, `The Cadbury Schweppes case: a win for taxpayers?', Ir. TR 2006, vol. 19, no. 4, pp. 96±106; J. O'Connor, `Impact of tax ruling yet to be seen', Ir. TR 2006, vol. 19, no. 4, p. 49; J. O'Connor, `AG Opinion in Cadbury Schweppes case', Ir. TR 2006, vol. 19, no. 4, p. 45; L. Sheppard, `Cadbury Schweppes: The ECJ Versus Tax Administration', Tax Notes, 7 August 2006, pp. 480±486; C.P. Schlindler, `Cadbury Schweppes Case Comment', WTD, 21 June 2006; C. Ehlermann, `News Analysis: Implications of Cadbury Schweppes Opinion on German CFC Legislation', WTD, May The hearing is scheduled for See Marks and Spencer, C-446/03 [2005] ECR I Even though the facts were `agreed', it seems clear from the subsequent application made on behalf of the applicants (after the case was referred to the ECJ) that a different interpretation of those facts could lead people in different directions, in particular, concerning what inferences could be drawn from the facts. This led to a dispute over what facts were common ground when the UK's Written Observations were put before the ECJ. The subsequent Directions hearing held by the Special Commissioners made it clear that there was a dispute between the parties over certain facts and ordered the publication of the Direction hearing. This is available at gov.uk/judgmentfiles/j1907/spc00512.doc (last visited 12 November 2006). 8 The facts outlined below are taken from the Special Commissioners' decision. 9 See para. 5 of the Special Commissioners' decision/order for Reference per cent of the subsidiary's profits were distributed to the parent within 18 months and taxed in the hands of the UK company. 14 EC TAX REVIEW 2007/1

3 (ii) `exempt activities' test; 11 (iii) a de minimis test; 12 (iv) `public quotation' requirement; 13 (v) a `motive test'. 14 Of these exclusions, the rationale for the `motive test' is perhaps the most important because it was argued that it allowed the UK Revenue to consider the particular circumstances of the taxpayer in the light of the essential purpose of the UK CFC rules to tax profits that are either accumulated abroad or diverted abroad from the UK ± in other words, making it a case-by-case examination. From the facts set out in the Special Commissioners' decision, when the motive test was applied, the main purpose of the transactions appeared to be the achievement of a reduction in UK tax and if the two Irish subsidiaries had not existed their profits would have been taxable in the UK. Accordingly, the UK Revenue considered that the UK's CFC rules were applicable Uncertainties Cadbury Schweppes argued that the UK's CFC rules were incompatible with Community law. As the Special Commissioners remained uncertain as to the application of Community law in these circumstances, it specified a number of issues on which it required the Court's guidance.. Whether Cadbury Schweppes was exercising a freedom when it established subsidiaries in another Member State ± or was this an abuse of such freedoms?. Were the UK's CFC rules a restriction of the freedoms or were they discriminatory?. Whether the fact that Cadbury Schweppes plc would pay no more tax than if the subsidiaries were established in the UK meant that there was no restriction of the freedoms?. Whether it was relevant that the rules for calculating the income of the Irish subsidiaries differ in some respects from the rules applicable to UK subsidiaries of Cadbury Schweppes ± (for instance, there was no loss relief granted if the Irish subsidiaries incurred losses)?. What was the correct comparison for determining discrimination in this situation ± a comparison with a UK parent establishing subsidiaries in the UK or in some other Member State where the UK CFC rules did not apply because the level of taxation there was not as low as the rate in Ireland?. Whether the UK CFC rules could be justified by the need to prevent tax avoidance ± in particular, given the opportunity provided by the `motive test' to Cadbury Schweppes plc to show that it did not have a tax-avoiding motive by satisfying both limbs of that test? 2. The Opinion of Advocate-General Leger Advocate-General Leger found that the UK CFC rules were compatible with Community law if the CFC legislation: 16 (a) only applied to `wholly artificial arrangements intended to circumvent national law'; and (b) allowed the taxpayer to be exempted from the CFC rules `by providing proof that the controlled subsidiary is genuinely established in the State of establishment and that the transactions which have resulted in a reduction in the taxation of the parent company reflect services which were actually carried out in that State and were not devoid of economic purpose with regard to that company's activities'. 17 The Advocate-General determined that freedom of establishment was at `the core of the proceedings' 18 and divided his analysis into three segments. First, was it an abuse of the freedom of establishment for Cadbury Schweppes plc to establish subsidiaries in Ireland for the purpose of obtaining a more favourable tax rate? Secondly, if it was not an abuse, did the UK's CFC rules hinder the exercise of the freedom of establishment? Thirdly, if there was a restriction of the freedom of establishment, could the CFC rules be justified? 2.1. Abuse of the freedom of establishment Perhaps, the most fundamental issue in this case is whether or not Cadbury Schweppes plc was actually exercising its freedom of establishment rights in Ireland, or whether this purported use of the EC Treaty freedom was an abuse of rights and consequently a nullity. The Advocate-General found that the UK parent was exercising its freedom of establishment rights provided that it was operating a genuine and active economic activity in Ireland. 19 Establishing the subsidiaries in Ireland for the purpose of benefiting from a more favourable tax regime did not constitute, `in itself, an abuse of freedom of establishment'. 20 The Advocate-General recognized that an `abuse' might exist where the `establishment' in the host state was 11 Certain specified activities, such as trading activities, were exempt from the application of the CFC rules. 12 The CFC rules did not apply to the profits of subsidiary if they did not exceed 50, The subsidiary is quoted on a recognised stock exchange and 35 per cent of the voting power must be in the hands of the public. 14 The `motive test' comprises of two limbs ± a taxpayer must satisfy both limbs in order to avoid the application of the CFC rules. The first limb requires the taxpayer to show that if there is a reduction in UK tax as a result of the transactions with the foreign subsidiary, that the reduction in UK tax was not the purpose, or one of the main purposes, of those transactions. The second limb requires the taxpayer to demonstrate that the diversion of profits from the UK to the subsidiary was not the main reason, or one of the main reasons for the existence of the subsidiary. For an application of the `motive test' see ABTA Ltd v IRC [2003] STC (SCD) 194 [Special Commissioners' Decision]. 15 See paras. 7 and 8 of the Special Commissioners' decision. 16 See para. 151 of the Opinion of Advocate-General Leger in Cadbury Schweppes. 17 See para. 151 of the Opinion. 18 See para. 36 of the Opinion. 19 See para. 42 of the Opinion. 20 See para. 40 of the Opinion. EC TAX REVIEW 2007/1 15

4 not genuine; however, he made it clear that reasons for the establishment were not relevant: `as long as there is a genuine and actual pursuit of an activity by the controlled subsidiary in the Member State in which it was established, the reasons which the parent company decided to establish the subsidiary in that host State cannot call into question the rights which that company derives from the Treaty'. 21 Moreover, the Advocate-General commented that the level of taxation was a location factor which companies can legitimately consider when deciding whether or not to establish a subsidiary. `A company may, without infringing the scope and spirit of Article 43 EC, decide to pursue its secondary activities in another Member State in order to benefit from the more favourable tax regime of that other State in respect of taxable activities in that State.' 22 In the absence of harmonized rules relating to tax rates in Member States, a certain amount of tax competition had to be recognized; such disparities in tax rates could have a significant impact on companies when they made location decisions for their activities in the EU. 23 Consequently, a UK company setting up subsidiaries in Ireland `for the avowed purpose of enjoying the more favourable tax regime' did not, in itself, constitute an abuse of the freedom of establishment Restriction The Advocate-General then moved onto analysing whether or not the UK CFC rules constituted a hindrance of the freedom of establishment and found that the different treatment of Cadbury Schweppes plc deterred or disadvantaged that company from establishing a subsidiary in Ireland compared to establishing a subsidiary in the UK or in a Member State where the UK CFC rules did not apply. 25 The disadvantages were apparent ± in a UK-UK situation, the UK resident parent was never taxed on its subsidiary's profits; in a UK-MS (a Member State where the UK CFC rules did not apply) situation, the UK parent company was never taxed on the profits of its subsidiary on an arising basis. It could only be taxed on those profits when distributed to it as a dividend. 26 In dealing with the UK's argument that the tax imposed on the UK parent company was no more than it would have paid if its subsidiaries were established in the UK instead of Ireland, the Advocate-General said that this still did not eliminate the disadvantageous treatment at the parent company level. 27 A Member State could not `treat differently its resident companies which establish subsidiaries in other Member States depending on the tax rate applicable in the host State'. 28 Such treatment ran counter to the approach taken by the Court in Eurowings 29 where the Court decided that low taxation in the Member State of the service provider could not justify unfavourable tax treatment in the Member State of the service recipient; and in Barbier 30 where the Court made it clear that: `a Community national cannot be deprived of the right to rely on the provisions of the Treaty on the ground that he is profiting from tax advantages which are legally provided by the rules in force in a Member State other than his State of residence'. 31 The Advocate-General concluded by finding that the different treatment of UK companies by the CFC rules constituted a hindrance to the freedom of establishment. The remaining question was whether such a restriction was justified Justification The UK's primary defence was that the CFC rules were adopted to counter tax avoidance by the artificial diversion of profits made in the UK to other jurisdictions with more favourable tax regimes. 32 The Advocate-General accepted that preventing tax avoidance was an overriding reason in the public interest capable of justifying a restriction on the freedom of establishment but that such a defence had a rather limited scope in the jurisprudence of the Court as the legislation must first of all be `specifically designed to exclude from a tax advantage wholly artificial arrangements aimed at circumventing national law'. 33 In other words, `[a]pplication of Community law may be refused only when the company in question relies on it abusively because it has set up an artificial arrangement in order to avoid tax'. 34 And secondly, the anti-abuse legislation cannot be defined too generally 35 ± national courts can, on a case-by-case basis, deny EC Treaty benefits where there is abuse or fraudulent conduct, on the basis of objective evidence. 36 Thus, national courts must have the opportunity to assess the taxpayer's conduct and have the right to refuse `case by case, the benefit of Community law to certain taxpayers or certain companies which have made use of an artificial arrangement for the purpose of avoiding tax'. 37 The Advocate-General noted two interesting points from the recent Marks and Spencer judgment: 21 See para. 49 of the Opinion. 22 See para. 51 of the Opinion. 23 See para. 55 of the Opinion. 24 See para. 60 of the Opinion. 25 This is an application of the `migrant/non-migrant' test discussed in the fourth section of this article. See T. O'Shea, `Freedom of Establishment Jurisprudence: Avoir Fiscal Revisited on its 20th Anniversary', YEL 2006 (forthcoming); T. O'Shea, `Marks and Spencer v David Halsey (HM Inspector of Taxes): Restriction, Justification and Proportionality', EC Tax Review 2006, no. 2, pp. 66± See para. 74 of the Opinion. 27 See para. 76 of the Opinion. 28 See para. 81 of the Opinion. 29 See Eurowings, C-294/97 [1999] ECR I-7447, para See Barbier C-364/01 [2003] ECR I-15013, para See para. 82 of the Opinion. 32 See para. 85 of the Opinion. 33 See para. 87 of the Opinion. 34 See para. 88 of the Opinion. 35 See para. 89 of the Opinion. 36 See para. 91 of the Opinion. 37 See para. 92 of the Opinion. 16 EC TAX REVIEW 2007/1

5 (a) that the freedoms `are not designed to enable companies to transfer their profits and losses from one Member State to another to suit their convenience' and consequently, the Member States may thus prevent such transfers; 38 and (b) reduction in tax revenue cannot constitute an overriding reason in the public interest to justify a restriction of a fundamental freedom ± thus, the Member State in which the parent company is established cannot prevent the establishment of a subsidiary in another Member State `using the pretext... that the activities carried on by it there could be carried on in its own territory and fall within its tax sovereignty'. 39 The Advocate-General considered that transactions between a parent company and its controlled subsidiary should be examined with these two principles in mind when trying to ascertain whether the transactions constitute tax avoidance. 40 He notes that the provision of services by a subsidiary to its parent is an: `economic activity which takes the form of transactions between distinct legal persons. The fact that those companies are linked does not prevent the pricing of those transactions from being determined under normal competitive conditions. 41 The risk of tax avoidance in connection with such transactions is not therefore comparable to that which would be created by the transfer of losses of foreign subsidiaries to a resident parent company, at issue in Marks and Spencer, since such a transfer would be done by merely adjusting the accounts. Transactions between a CFC and its parent company which result in reducing the taxable profits of the latter can therefore be regarded as tax avoidance only if the establishment of that subsidiary and those transactions constitute... a wholly artificial arrangement aimed at circumventing national law'. 42 Thus, the Advocate-General's view is that as long as the subsidiary providing the intra-group services is `carrying on genuine economic activity in the host state, under the tax sovereignty of which it falls, the territorial allocation of the Member States' power to impose taxes is not, a priori, affected. The loss of taxable profits affecting the state of origin is the result of the economic activity which is carried on in the host state and taxed by that state'. 43 Thus, ascertaining whether there is a wholly artificial arrangement entails a case-by-case assessment of `whether the subsidiary is genuinely established in the host State and carries on its activities in that State'. 44 Three criteria are put forward which the Advocate- General considers to be relevant in making the assessment of whether an establishment is genuine: the degree of physical presence in the host state (premises, staff and equipment to carry out the services); the genuine nature of the services provided by the subsidiary; and the economic value of that activity with regard to the parent company and the group. 45 However, he rejects the motives for establishing a subsidiary and for the choice of the host state as being a relevant criterion because `the existence of a wholly artificial arrangement cannot be inferred from the parent company's avowed purpose of obtaining a reduction of its taxation in the State of origin'. 46 Consequently, he finds that a wholly artificial arrangement intended to avoid national tax law can only be established on the basis of objective factors Proportionality The Advocate-General next analyses whether the UK's CFC rules are suitable for countering tax avoidance and whether they go beyond what is necessary to achieve that purpose. He concludes that the UK's rules achieve their purpose because they add the profits made by the CFC to the UK parent company's tax base and thus cancel any tax avoidance involved. 48 Next he examines whether the UK's CFC rules go too far and notes that they are `designed to apply only in very specific circumstances which correspond to cases in which the probability of the risk of tax avoidance is highest'. 49 As the intra-group treasury services in question are highly mobile and could be easily manipulated in the name of the CFC by staff and information technology not located in Ireland, the CFC may have no real substance in the host state and may be simply a `letter-box company'. In such circumstances the Advocate-General accepts that it may be necessary for the UK CFC rules to establish a presumption of tax avoidance which must be rebutted. 50 This gives an element of legal certainty to economic operators because they are put on notice that they must be able to show that their CFC is genuinely established in the host state and that the transactions between the CFC and the parent company are real. 51 The Advocate-General sees it as critical that this presumption can actually be rebutted because even though the parent company has achieved a significant tax saving by relocating the services in question in the host Member State, that fact, together with the failure of the CFC to fulfil any of the exclusions, does not `suffice to show the existence of a wholly artificial arrangement' 52 ± they may reflect genuine business carried on in the host state. Consequently, the Advocate-General concludes that the presumption must be capable of being rebutted and the application of the CFC rules must be restricted to wholly 38 See para. 102 of the Opinion. 39 See para. 103 of the Opinion. 40 See para. 104 of the Opinion. 41 The OECD Transfer Pricing Guidelines are cited. 42 See para. 108 of the Opinion. 43 See para. 109 of the Opinion. 44 See para. 110 of the Opinion. 45 See para. 111 of the Opinion. The Court did not follow this piece of the Advocate-General's Opinion in its subsequent judgment. 46 See para. 115 of the Opinion. 47 See para. 117 of the Opinion. 48 See para. 125 of the Opinion. 49 See para. 137 of the Opinion. 50 See para. 140 of the Opinion. 51 See para. 141 of the Opinion. 52 See para. 143 of the Opinion. EC TAX REVIEW 2007/1 17

6 artificial arrangements designed to circumvent national law. 53 The `motive test' is then examined to see if it provides the necessary opportunity to taxpayers to rebut the presumption of tax avoidance in these circumstances. The Commission and certain Member States had argued that the motive test was not satisfactory in this respect because the UK Revenue did not have to perform any analysis of the Irish subsidiary's activities and the motive test also covered legitimate arrangements which were established with a tax saving/mitigation aim but which were not wholly artificial arrangements. 54 The Advocate-General agreed that the decision of a company to `centralise the performance of services in a Member State with very favourable taxation for the purpose of reducing its tax burden does not prove the existence of a wholly artificial arrangement'. 55 However, the Advocate-General suggests that `it is not certain that the motive test should be given that interpretation' 56 and concluded that it was for the national court to assess `whether the motive test may be given an interpretation which makes it possible to limit the application of that law to artificial arrangements intended to circumvent national tax law' Conclusion As such, Advocate-General Leger concludes that the UK's CFC rules are not incompatible with the freedom of establishment provided that the rules only apply to wholly artificial arrangements intended to circumvent national law and the rules allow the taxpayer to be exempted by proving that the CFC is genuinely established in the host state and that the treasury services were actually carried out in that state and were not devoid of economic purpose with regard to that company's activities The Judgment of the European Court of Justice 3.1. Introductory remarks The Court found that the UK's CFC rules could be compatible with Community law if they specifically targeted wholly artificial arrangements designed to circumvent national tax law. However, the Court expressed sufficient doubts in its judgment, in giving its guidance to the national court that it is likely that the UK's CFC rules will have to be radically overhauled to comply with the requirements of Community law as set out in the judgment Freedom of establishment The Court confirmed that the UK's CFC rules should be examined in the light of the ECT's freedom of establishment provisions. 59 The UK's CFC rules concerned the taxation of profits of certain subsidiaries established outside the UK in which a UK resident company had a controlling holding. As such, this brought the CFC legislation within the scope of freedom of establishment because the UK parent company had a `definite influence' over the CFC's decisions; the Court's settled jurisprudence since Baars 60 applied. 61 It held that even though the CFC rules might have effects on the freedom to provide services and the free movement of capital also, `such affects are an unavoidable consequence of any restriction on freedom of establishment and do not justify... an independent examination of that legislation in the light of Articles 49 EC and 56 EC' Abuse of the freedom of establishment The first issue dealt with by the Court was whether there was an abuse of the freedom of establishment when the UK parent established a subsidiary in Ireland's IFSC in order to benefit from the special low tax regime. It held that this, in itself, did not constitute abuse. 63 The Court's reasoning was based on settled case law: Community law could not be used by EU nationals to improperly circumvent national legislation 64 but profiting from tax advantages available in another Member State could not deprive a person of the right to rely on provisions of the EC Treaty. 65 Taking advantage of more favourable company formation rules had also been accepted by the Court in its Centros judgment, 66 and in Inspire Art the Court confirmed 67 that `the fact that a company was established in a Member State for the purpose of benefiting from more favourable legislation does not in itself suffice to constitute abuse of the freedom'. 68 Consequently, the Court moved on to examine the next issue, whether or not the UK's CFC rules constituted a restriction on the freedom of establishment. 53 See para. 144 of the Opinion. 54 See para. 147 of the Opinion. 55 See para. 148 of the Opinion. 56 See para. 149 of the Opinion. Advocate-General Leger makes the point that it is not clear if the first limb of the motive test gives the taxpayer the opportunity to show that the treasury services in question are real and genuine. Similarly, in relation to the second limb of the test, it is not clear whether it can be satisfied by the taxpayer demonstrating that the subsidiary is genuinely established in the host Member State. 57 See para. 150 of the Opinion. 58 See para. 151 of the Opinion. 59 See Cadbury Schweppes, C-196/04, para See Baars, C-251/98 [2000] ECR I-2787, para. 22. In Baars, the Court confirmed that freedom of establishment was applicable when one person's holding in a company gave that person a definite influence over the company's decisions and allowed that person to determine its activities. 61 Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para See Knoors, 115/78 [1979] ECR Cadbury Schweppes, paras. 35±36. The Court based this reasoning on Barbier, C-364/01, para See Centros, C-212/97 para See Inspire Art, C-167/01 [2003] ECR I para Cadbury Schweppes, para EC TAX REVIEW 2007/1

7 3.4. Restriction on the freedom of establishment It was common ground that the UK's CFC rules involved different treatment of UK parent companies based on the level of taxation imposed on their controlled subsidiary. If the subsidiary was incorporated in a much lower tax jurisdiction (and the UK's CFC rules applied), the profits of the subsidiary were attributed to the UK parent company on an arising basis. If the UK company had established the subsidiary in either the UK or in another Member State (where the UK's CFC rules did not apply because the level or taxation was considered acceptable under the UK's rules), the UK parent company would not have the profits of the subsidiary attributed to its tax base: the UK parent company is taxed on the profits of another legal person 69 when the CFC rules apply. Consequently, this different treatment constituted a tax disadvantage likely to restrict the freedom of establishment. 70 Therefore, following the Gebhard formula, 71 such a restriction must be justified and measured against the principle of proportionality Justification The overriding reason in the public interest put forward to justify the UK's CFC rules was to prevent a form of tax avoidance involving the artificial transfer by a UK resident company of profits made in the UK to a low-tax state by means of the formation of a subsidiary in the host state (Ireland) and carrying out transactions primarily to transfer profits to that subsidiary. 72 The Court responded in its normal way by pointing out that the reduction of tax revenue was not one of the grounds listed in Art. 46(1) of the EC Treaty or a matter of overriding general interest. 73 More importantly, the Court reminded Member States that: `any advantage resulting from the low taxation to which the subsidiary established in a Member State other than the one in which the parent company was incorporated is subject cannot by itself authorise that Member State to offset that advantage by less favourable tax treatment of the parent company'. 74 Furthermore, in considering the concept of tax avoidance, the Court made it clear that a general presumption of tax avoidance could not be drawn from the fact that the UK parent company had established a subsidiary in another Member State. 75 The Court had already made this point in its ICI judgment. 76 However, the Court's case law had also made it clear that national rules which restrict the freedom of establishment could be justified where they specifically relate to `wholly artificial arrangements aimed at circumventing' national law Objective of the freedom of establishment When examining the conduct of the parent company in this instance, the Court indicated that it was necessary to take into account the objective of the freedom of establishment 78 which was to assist `economic and social interpenetration within the Community' and `to allow a Community national to participate on a stable and continuing basis, in the economic life' of the host Member State `and to profit therefrom'. 79 Consequently, bearing this objective in mind, according to the ECJ the concept of `establishment' in the EC Treaty involved the `actual pursuit of an economic activity through a fixed establishment in that state for an indefinite period', in other words the subsidiary in Ireland must have been an actual establishment and it must have pursued `genuine economic activity there'. 80 The Court summarizes its case law in this area by saying that: `in order for the restriction on the freedom of establishment to be justified on the ground of prevention of abusive practices, the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping tax...' Cadbury Schweppes, para Cadbury Schweppes, paras. 43± See Gebhard, C-55/94 [1995] ECR I-4165, para. 37. The Court said `national measures liable to hinder or make less attractive the exercise of fundamental freedoms guaranteed by the Treaty must fulfil four conditions: they must be applied in a nondiscriminatory manner; they must be justified by imperative requirements in the general interest; they must be suitable for securing the attainment of the objective which they pursue; and they must not go beyond what is necessary in order to attain it'. 72 Cadbury Schweppes, para. 48. In Lenz, a free movement of capital case, the Court explicitly stated that `the level of taxation on companies established in another Member State is not relevant in relation to Austrian tax legislation when assessing the compatibility of national tax legislation' with the free movement of capital. See Lenz C-315/02 para Cadbury Schweppes, para Cadbury Schweppes, para. 49. This re-echoed the Court's judgment in Eurowings where it had made this point in relation to the freedom to provide services. See Eurowings, C-294/97 [1999] ECR I-7447, para. 44. See further discussion in the fourth section of this article. 75 Cadbury Schweppes, para See ICI, C-264/96 [1998] ECR I-4695, para. 26 where the Court noted `the legislation at issue in the main proceedings does not have the specific purpose of preventing wholly artificial arrangements, set up to circumvent United Kingdom tax legislation, from attracting tax benefits, but applies generally to all situations in which the majority of a group's subsidiaries are established, for whatever reason, outside the United Kingdom. However, the establishment of a company outside the United Kingdom does not, of itself, necessarily entail tax avoidance, since that company will in any event be subject to the tax legislation of the State of establishment'. 77 Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para. 54. See Factortame and others, C-221/89 [1991] ECR I-3905, para. 20 where the Court said that `the concept of establishment within the meaning of Art. 52 et seq. of the Treaty involves the actual pursuit of an economic activity through a fixed establishment in another Member State for an indefinite period'. 81 Cadbury Schweppes, para. 55. EC TAX REVIEW 2007/1 19

8 3.7. Balance in the allocation of taxing rights between Member States In Marks and Spencer, 82 the Court had noted that `loss trafficking' between group companies situated in different Member States in order to obtain the most advantageous tax rates can be curtailed by the Member States to ensure that a balanced allocation of taxing rights between the Member States could be protected. In Cadbury Schweppes, the Court draws an analogy from this reasoning in relation to the diversion of profits to CFCs 83 and noted that this type of conduct might equally undermine a Member State's tax jurisdiction and disturb the balance in the allocation of taxing rights between Member States Prevention of wholly artificial arrangements The Court next examined whether the UK's CFC rules met their objective and concluded that the UK's rules do prevent practices which have no purpose other than escaping national tax rules Proportionality Next, the Court had to assess whether the UK's CFC rules were proportionate and, even though they were suitable for achieving the objective of the legislation, whether they went beyond what was necessary to achieve that purpose. Consequently, the ECJ analysed the UK's CFC rules and, quite significantly, noted that even if none of the exceptions to the CFC rules applied and that the intention to obtain the tax advantage was the reason why the controlled subsidiary was established in Ireland, these facts alone were not sufficient to conclude that there was a wholly artificial arrangement intended solely to escape UK tax Wholly artificial arrangement The Court determined, in a similar way to its Halifax judgment, 86 that there were two tests involved in ascertaining whether arrangements were `wholly artificial': first, there was a subjective test ± in other words, there must be an intention to obtain a tax advantage; secondly, an objective test, which must also be satisfied, showing that `the objective pursued by the freedom of establishment... has not been fulfilled'. 87 Therefore, for the UK's CFC rules to comply with Community law, UK taxation under the CFC regime must be excluded where `the incorporation of the CFC reflects economic reality' despite the existence tax motives. 88 The Court explains that such `incorporation' must involve `an actual establishment intended to carry on genuine economic activities in the host Member State' 89 and, in this respect, that finding must be based on: `objective factors which are ascertainable by third parties with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment 90...[If] the CFC is a fictitious establishment not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement. That could be so in particular in the case of a ``letterbox'' or ``front'' company'. 91 However, the Court insisted that the UK parent company must be given the opportunity to `produce evidence that the CFC is actually established and that its activities are genuine'. 92 Furthermore, the Court rejected the argument that the fact that the activities of the CFC could just as easily have been carried out in the UK meant that there was a wholly artificial arrangement in place. 93 The evidence furnished by the UK parent company could be verified by using Council Directive 77/799/EEC (the Mutual Assistance Directive), as amended, and the UK-Ireland Double Tax Convention Conclusion The Court referred the matter back to the national court to decide whether one of two situations existed in applying the `motive test' contained in the UK's CFC rules: if the national court finds that the motive test can be interpreted in a way which restricts taxation to wholly artificial arrangements, then such CFC rules are compatible with the freedom of establishment. However, if the motive test means that where: (a) none of the exceptions to the UK's CFC rules applies; (b) the intention to obtain a reduction in UK tax is central to the reasons for incorporating the CFC; and (c) the UK parent company comes within the scope of the CFC rules, despite the absence of objective evidence to indicate that a wholly artificial arrangement exists, then in such circumstances the UK CFC rules are incompatible with the freedom of establishment. 94 In other words, the Court is satisfied that CFC rules can be compatible with Community law provided they are targeted at wholly artificial arrangements intended to escape the national tax normally payable. However, the Court is adamant that UK CFC rules: `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 82 See Marks and Spencer, paras. 46 and Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para See Halifax, C-255/02 [2006] ECR I-0000 paras. 74± Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, paras. 72± EC TAX REVIEW 2007/1

9 actually established in the host Member State and carries on genuine economic activities there' Analysis The Cadbury Schweppes judgment is very important because of the impact it will have on the CFC rules of Member States. The judgment draws a clear distinction between tax avoidance and tax mitigation in line with previous ECJ decisions: tax mitigation is clearly acceptable to the ECJ. 96 The Court confirmed that `forum shopping' and `rule shopping' is allowed in an internal market context if there is a legitimate exercise of the fundamental freedoms. This is again in keeping with settled case law, and the motives for carrying out a transaction, though relevant, may not trigger automatic proof of actual tax avoidance/evasion. The judgment throws new light on the concept of `establishment' and the relationship between the freedom of establishment, the freedom to provide services and the free movement of capital. It extends the reasoning of the Court in Marks and Spencer which introduced the justification of the need to ensure a balanced allocation of taxing rights between Member States: the Cadbury Schweppes judgment provides new comments to assist our understanding of this new justification in the tax field. More generally, the judgment confirms that competence in relation to direct tax matters remains with the Member States who can set their own tax rates ± including a zero rate. Further, in keeping with a trend in its jurisprudence, the judgment confirms that the `migrant/nonmigrant test' from the origin state perspective is the correct comparison when determining whether discrimination/restriction exists when an origin Member State resident exercises a fundamental freedom. Finally, and perhaps of most significance, the Court gives a much needed clarification of the concept of `abuse' of the freedom of establishment and some guidance on the requirements of a genuine `establishment' within an internal market context Tax avoidance versus tax mitigation The Court's jurisprudence relating to the concept of `tax avoidance' has revealed a clear distinction between `tax avoidance' and `tax mitigation' from at least the time of the ICI judgment. 97 In ICI, the Court made it clear that the UK consortium relief legislation did not necessarily constitute anti-avoidance legislation, because it did: `not have the specific purpose of preventing wholly artificial arrangements, set up to circumvent United Kingdom legislation, from attracting tax benefits, but applies generally to all situations in which the majority of a group's subsidiaries are established, for whatever reason, outside of the United Kingdom. However, the establishment of a company outside the United Kingdom does not, of itself, necessarily entail tax avoidance, since that company will in any event be subject to the tax legislation of the State of establishment'. 98 Thus, in ICI, the Court clearly sees tax avoidance as encompassing the concept of `wholly artificial arrangements' designed to circumvent UK tax legislation. Similarly, in a pure inheritance tax planning/mitigation case, Barbier, where the taxpayer took advantage of some Dutch rules which allowed the legal title to immovable property to be separated from its so-called financial ownership, thus, allowing him to reduce the taxable value of his estate on his death, the Court found that: `a Community national cannot be deprived of the right to rely on the provisions of the Treaty on the ground that he is profiting from tax advantages which are legally provided by the rules in force in a Member State other than his State of residence'. 99 In other words, the Court accepts that certain types of tax planning/mitigation are acceptable in an internal market context. In relation to the free movement of capital in Barbier, and also in a freedom of establishment situation in ICI, the Court accepted that it was possible to exercise one of the fundamental freedoms in a way which did not trigger a tax avoidance defence/justification for the Member States seeking the restrict the use of the freedoms when obtaining a tax advantage was at stake. Similarly, in the area of free movement of services, different tax treatment of German undertakings according to whether they obtained their leasing services from German providers or service providers located in other Member States could not be justified on the ground that the non-german service providers were subject to a lower level of taxation. For instance, in Eurowings, the Court said that `any tax advantage resulting for providers of services from the low taxation to which they are subject in the Member State in which they are established [Ireland] cannot be used by another Member State [Germany] to justify less favourable treatment in tax matters given to recipients of services established' in Germany. The Court emphasized that `such compensatory arrangements prejudice the very foundations of the Single Market. 100 More recently, in relation to VAT, the Court was called to adjudicate upon a VAT-planning scheme, in the Halifax case. 101 The ECJ indicated that: `Preventing possible tax evasion, avoidance and abuse is an objective recognised and encouraged by the Sixth Directive [However]... it is clear from the case-law that a trader's choice between exempt transactions and taxable transactions may be based on a range of factors, including tax considerations relating to the VAT system.... Where the taxable person chooses 95 Cadbury Schweppes, para As it was, for example, in Barbier. Professor Frans Vanistendael correctly points out that the ECJ has `Europeanised' the concept of abuse. I am grateful to Professor Vanistendael for showing me an advance copy of his Editorial on Cadbury Schweppes due for publication in EC Tax Review 2006, no See ICI v Colmer (HMIT), C-264/96 [1998] ECR I ICI, para Barbier, para See Eurowings, paras. 44 and See Halifax, C-255/02 [2006] ECR I Halifax, para. 71. EC TAX REVIEW 2007/1 21

10 one of two transactions, the Sixth Directive does not require him to choose the one which involves paying the highest amount of VAT. On the contrary... taxpayers may choose to structure their business so as to limit their tax liability'. 103 The Court in Halifax, therefore, draws a distinction between `tax avoidance' and `tax planning/mitigation' ± it sees tax planning/mitigation as a legitimate option of the taxpayer without defining where the fine line is drawn. This brings to mind the words of Lord Tomlin in the famous Duke of Westminster, House of Lords' decision, in the UK: `Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax. This so-called doctrine of `the substance' seems to me to be nothing more than an attempt to make a man pay notwithstanding that he has so ordered his affairs that the amount of tax sought from him is not legally claimable'. 104 Some examples of pure tax avoidance were outlined by the Court in its Marks and Spencer judgment: in a cross-border group relief setting there was a danger that losses would be used twice (so-called `double-dipping'); 105 and the possibility of transferring losses cross-border would give groups of companies the opportunity of transferring losses to companies established in Member States with the highest rates of taxation because this would maximise the value of those losses for the group as a whole (so-called `losstrafficking'). In both of these instances, the Court was satisfied that the UK could have domestic rules to prevent such tax avoidance from occurring. In other words, the UK's rules on group relief could be restricted to domestic situations in these instances and did not have to be extended cross-border. Additionally, in concluding, the Court reminded the Member States that: `all Member States are free to adopt or maintain in force rules having the specific purpose of precluding from a tax benefit wholly artificial arrangements whose purpose is to circumvent or escape national tax law'. 106 The Court applied this reasoning in Cadbury Schweppes, but in doing so had to balance the rights of Community nationals and the rights of Member States to protect against tax avoidance involving wholly artificial arrangements aimed at circumventing national tax law, in this instance, UK companies who had established subsidiaries in low tax Member States. The Court said that such an exercise of the freedom of establishment, in itself, could not `set up a general presumption of tax evasion and justify a measure which compromises the exercise of a fundamental freedom'. 107 Consequently, the Court looks at the conduct of the UK parent company in question and takes into account the aim of the freedom of establishment. It concluded that for the restriction on the freedom of establishment to be justified on the ground of preventing tax avoidance: `the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits carried out on national territory'. 108 The Court is, therefore, emphasising that there must be a specific enquiry involved ± similar to its case by case analysis discussed above and confirmed in its ICI 109 and De Lasteyrie 110 jurisprudence. Secondly, the arrangements involved must be `wholly' artificial ± therefore, arrangements which are not `wholly' artificial are arguably not covered by the concept of tax avoidance. The Court sees tax mitigation motives in themselves as not necessarily constituting tax avoidance and `wholly artificial arrangements'. 111 An additional element must be present. There must be objective evidence showing that despite the `formal observance' of the right of establishment, the aim of that Treaty provision has not been achieved. Thus, in relation to `letter-box' companies, the Court resurrects its reasoning in Eurofood IFSC, 112 and finds that the objective evidence should be: (a) ascertainable by third parties, 113 (b) there should be an actual establishment ± in terms of premises, staff and equipment, 114 and (c) `genuine economic activities in the territory of the host Member State' should be carried on Halifax, para See the judgment given by Lord Tomlin in Duke of Westminster v CIR, House of Lords, [1936] AC 1. This dictum was commented upon subsequently by Lord Diplock in IRC v Burmah Oil Company who made the point that the Ramsay case marked a significant change in approach by the House of Lords and that it should be recognized that Lord Tomlin's dictum `tells us little or nothing as to what methods of ordering one's affairs will be recognised by the courts as effective to lessen the tax that would attach to them if business were conducted in a straight-forward way'. See the judgment of Lord Diplock in IRC v Burmah Oil Co Ltd [1982] STC 30, and WT Ramsay v IRC [1982] AC See Marks and Spencer, para See Marks and Spencer, para Cadbury Schweppes, para Cadbury Schweppes, para. 55 (emphasis is added). 109 See ICI, para See De Lasterie du Saillant [2004] ECR I-2409, para. 50 where the Court said: `it should be noted that Article 167a of the CGI is not specifically designed to exclude from a tax advantage purely artificial arrangements aimed at circumventing French tax law, but is aimed generally at any situation in which a taxpayer with substantial holdings in a company subject to corporation tax transfers his tax residence outside France for any reason whatever'. 111 Cadbury Schweppes, para See Case C-341/04 Eurofood IFCS Ltd ± Enrico Bondi v Bank of America N.A., Pearse Farrell, Official Liquidator, Director of Corporate Enforcement, Certificate/Note holders (`Eurofood IFSC'), [2006] ECR I-3813, paras. 33±36. Although the case involved a Community Regulation and not an EC Treaty Article, the same principles apply. 113 Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para EC TAX REVIEW 2007/1

11 In other words, if a UK parent company sets up a subsidiary in Ireland to take advantage of the lower tax rates there ± this is a formal exercise of the right of establishment ± such an exercise may be challenged if it can be shown, on the basis of objective factors which are ascertainable by third parties, that the Irish subsidiary is a fictitious establishment not carrying out any genuine economic activity in Ireland. 116 The Court gives as an example of this type of situation, the case of a `letterbox' or `front' subsidiary. 117 Therefore, whenever the concept of tax avoidance is connected with the exercise of a Community freedom, there are two elements involved ± an objective test where, `despite the formal observance of the conditions laid down by the Community rules, the purpose of those rules has not been achieved', in this instance, the freedom of establishment has not been successfully engaged; 118 and a subjective test where the UK parent company intends `to obtain an advantage from Community rules by creating artificially the conditions laid down for obtaining it'. 119 The Court rejects the argument that if the Irish subsidiary's services could have been equally conducted in the UK, that that constituted tax avoidance. The Court makes it clear that this is not the case. 120 Furthermore, the UK parent company in these circumstances must be given the opportunity of rebutting the alleged tax avoidance, through the production of `evidence that the CFC is actually established and that its activities are genuine' Abuse The reasoning in the previous paragraphs concerning `tax avoidance' echoes the Court's jurisprudence in the area of abuse when the exercise of the fundamental freedoms comes into play. Thus in Kefalas, 122 where the free movement of capital was involved, the Court stated that `Community law cannot be relied upon for abusive or fraudulent ends' but noted also that the mere exercise of the right granted under the Community Directive in question cannot in itself be abusive. Domestic rules can therefore prevent an improper advantage being obtained `manifestly contrary to the objective of that provision'. Similarly, in relation to services, the Court noted in Deliege, that for the provision of certain `sporting' services to be an economic activity `the work performed must be genuine and effective and not such as to be regarded as purely marginal and ancillary'. 123 Furthermore, in Lair, 124 the Court confirmed that certain exercises of the fundamental freedoms (in this case the right of free movement of workers), which were abusive, were not covered by the freedom and can be prevented by domestic rules of the Member States provided that such abuse is established by `objective evidence'. 125 Consequently, the Member States retain significant powers over their territory and their own nationals even though the internal market exists and is functioning. A specific example of this dichotomy of treatment within a single market can be difficult to comprehend as was seen in the D case 126 where the Netherlands was allowed to have a double tax convention with Belgium which granted more favourable treatment to Belgian residents than under the Belgo-German DTC. When Mr. D argued that this constituted discrimination ± different treatment of two non-residents, the Court replied in the negative. 127 In the `abuse' context, Bouchoucha 128 provides another pertinent example of the problem. Here, a French national obtained a diploma in osteopathy in the UK. Under French rules, only doctors could practice as osteopaths, so Bouchoucha was prosecuted under the criminal code for illegally practising medicine. As there was no Community definition of `osteopathy', the Court noted that it was up to each Member State to define the concept and to regulate the profession as long as it did not discriminate between its own nationals and those of other Member States operating in its territory. However, the Court concluded that: `it is not possible to disregard the legitimate interest which a Member State may have in preventing certain of its nationals, by means of facilities created under the Treaty, from attempting to evade the application of their national legislation as regards vocational training'. 129 Therefore, the Court is willing to accept a restriction of the freedoms in areas which have not been harmonized as long as the rules apply equally to their own nationals and residents of other Member States established or operating in their territory. Simply using the freedom of establishment or the right to move to another Member State to obtain a diploma which is 116 Cadbury Schweppes, para Cadbury Schweppes, para See Emsland-Starke, C-110/99 [2000] ECR I-11569, para Emsland-Starke, para Cadbury Schweppes, para Cadbury Schweppes, para See Kefalas, C-367/96 [1998] ECR I-2843, para. 20 and the case law cited there. 123 See Joined Cases C-51/96 and C-191/97 Deliege [2000] ECR I- 2549, para. 54. the Court made similar comments in Levin in relation to the free movement of workers. See Levin, C-53/81 para. 17 et seq. Interestingly the Court comments in para. 22 that once an effective and genuine activity as an employed person is carried on in the host state, then `the motives which may have prompted the worker to seek employment in the Member State concerned are of no account and must not be taken into consideration. 124 See Lair, 39/86 [1988] ECR I-3161, para Lair, para See Case C-376/03 D. v Inspecteur van de Belastingdienst, [2005] ECR I-5821 (`D case'). 127 For a full discussion of the D case see T. O'Shea, `The ECJ, the ``D'' case, double tax conventions and most favoured nations: Comparability and Reciprocity', EC Tax Review 2005, vol. 14, no. 4, pp. 190±201 and the secondary materials cited therein. See also S. van Thiel (ed.), The European Union's Prohibition of Discrimination, Most-Favoured-Nation Treatment and Tax Treaties: Opinions and Materials, Berlin: Confederation Fiscale Europeenne, See Case C-376/03 D v Inspecteur van de Belastingdienst, [2005] ECR I See Bouchoucha, C-61/89 [1990] ECR I Bouchoucha, para. 14 (citing Knoors, para. 25). See Knoors, 115/ 78 [1979] ECR 399. EC TAX REVIEW 2007/1 23

12 recognized in that other Member State but not in the origin state is seen as a possible abuse of the freedoms which can be curtailed by the Member States' domestic rules. In Halifax, the Court explained its understanding of `abuse' in a VAT planning context, saying that two elements had to be fulfilled: `an abusive practice can be found to exist only if, first, the transactions concerned, notwithstanding formal application of the conditions laid down by the relevant provisions of the Sixth Directive... result in the accrual of a tax advantage the grant of which would be contrary to the purpose of those provisions Second, it must also be apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage...the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages'. 131 The Court went on to give some guidance to the national court in Halifax on what this means, in the context of the Sixth Directive's key purpose ± that of ensuring fiscal neutrality. In sum, a taxable person under the VAT rules should be entitled to deduct any input tax relating to economic activities which are subject to output VAT. However, as the Court explained, first: `to allow taxable persons to deduct all input VAT even though, in the context of their normal commercial operations, no transactions conforming with the deduction rules of the Sixth Directive... would have enabled them to deduct such VAT, or would have allowed them to deduct only a part, would be contrary to the principle of fiscal neutrality and, therefore, contrary to the purpose of those rules. 132 [Secondly] whereby the transactions concerned must essentially seek to obtain a tax advantage...it is the responsibility of the national court to determine the real substance and significance of the transactions concerned. In so doing, it may take account of the purely artificial nature of those transactions and the links of a legal, economic and/or personal nature between the operators involved in the scheme'. 133 The Court in Cadbury Schweppes follows this line of reasoning in replying to the UK court's questions, indicating that both a subjective and objective test was involved: the subjective test ± requiring an intention to obtain the tax advantage; the objective test ± showing that the objective of the freedom of establishment was not really fulfilled by the incorporation of the subsidiaries in the IFSC. 134 If the UK CFC rules applied to a situation which `reflected economic reality', the Court made it clear that the CFC rules are not compatible with Community law because in such circumstances there was a real exercise of the freedom of establishment in Ireland. 135 The establishment in Ireland in such circumstances must be an actual establishment carrying on genuine economic activities Motive The Court's jurisprudence concerning abuse, and the intentions and motives for exercising a fundamental freedom and engaging the EC Treaty has been developing quite rapidly in the non-tax area in recent years as people use the rights granted under the EC Treaty in order to circumvent national rules in areas such as immigration and residency. Three cases in particular are worth mentioning as they colour the Court's thinking when it comes to deciding `tax avoidance' issues which have a similar flavour. The first case is Singh 137 which was decided in Here an issue arose concerning a free movement of worker/establishment situation where a UK national married a third country national in 1982 in the UK. Subsequently, the couple moved to Germany to work (from 1983±1985) and then returned to the UK where Singh (in 1986) was granted leave to remain in the UK because he was the spouse of a UK national. In 1987, the couple divorced and the UK authorities attempted to deport him. The question was whether the EC Treaty was engaged and whether Singh had acquired a Community law right to remain in the UK as the spouse of a Community national who had exercised her free movement rights in the European Community when she moved from Germany to the UK to set up a business in the UK. The Court recognized that the marriage was not a sham, 138 that the UK national had exercised Community law rights when she returned to the UK to establish her business, and that her spouse was entitled to equivalent rights of residency in the UK (as otherwise a Community national might be deterred from exercising the freedom of establishment rights guaranteed by the ECT). 139 Regarding the risk of fraud and so-called `marriages of convenience', the Court indicated that: `the facilities created by the Treaty cannot have the effect of allowing the persons who benefit from them to evade the application of national legislation and of prohibiting Member States from taking the measures necessary to prevent such abuse'. 140 This judgment can be said to have, perhaps, triggered `planning' situations using Community law rights of movement to generate residency rights for third country spouses, because it clarified the rights of Community nationals wishing to circumvent domestic immigration rules. If a Community national left their 130 Halifax, para Halifax, para Halifax, para Halifax, para. 81 (citing Emsland-Starke, para. 58). 134 Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para See The Queen v Immigration Appeal Tribunal and Surinder Singh, ex parte Secretary of State, C-370/90 [1992] ECR 4265 (`Singh'). 138 Singh, para Singh, paras. 18± Singh, para EC TAX REVIEW 2007/1

13 origin state to work in another Member State, their spouse (a non-community national) could go with them. If the Community national got married in the host Member State to the non-community national, then the couple could return to the origin Member State as having exercised Community law rules, thus putting themselves in the shoes of any other Community national exercising Community law rights in that origin state. It seems clear from the facts established in the Akrich case 141 and from the `scheme' undertaken in the Chen case 142 that advisers were involved in `residency-planning' to get around UK immigration rules. In Akrich, a Moroccan national was deported out of the UK on a number of occasions but still managed to return (on one occasion within a month of deportation!). Eventually, whilst unlawfully residing in the UK he married a UK citizen and applied for permission to remain in the UK as a spouse of a UK citizen. He was detained at the beginning of 1997; in June 1997 his wife moved to Ireland to establish herself; and in August 1997, Akrich was deported from the UK and, in accordance with his wishes, he was deported to Ireland. Mrs. Akrich had worked in Ireland from August 1997 and a few months later, in January 1998, applied for a revocation of the deportation order and in February 1998, for permission to enter the UK as the spouse of a person settled in the UK. Mrs. Akrich had employment offered to her in the UK from August The UK viewed the move to Ireland as no more than a temporary absence, deliberately designed to manufacture a right of residence for Akrich on his return to the UK, thereby circumventing the UK's immigration rules, and that Mrs. Akrich had not genuinely exercised rights under the EC Treaty as a worker in another Member State. The Immigration Adjudicator in the UK disagreed, and although having found as a fact that Mr. and Mrs. Akrich had moved to Ireland for the express purpose of exercising Community law rights to enable them to return to the UK, he nevertheless concluded that: `as a matter of law, there had been an effective exercise by Mrs Akrich of Community rights which had not been tainted by the intentions of the spouses, and that they had therefore not relied on Community law to evade the provisions of the United Kingdom's national legislation'. 143 The Court agreed and commented that `the motives which may have prompted a worker to seek employment in another Member State are of no account as regards his right to enter and reside in the territory of the latter State provided that he there pursues or wishes to pursue an effective and genuine activity'. 144 It went on to say that such motives were not `relevant in assessing the legal situation of the couple at the time of their return to the Member State of which the worker is a national'. Such conduct was not abuse. 145 However, the Court stated that there would be abuse if marriages of convenience were involved with the exercise of Community rights to obtain residency rights for third country nationals. 146 As the marriage was genuine, the Court found that the fact that the spouses installed themselves in Ireland so that on their return to the UK they could obtain the benefit of rights conferred by Community law was not relevant to an assessment of their legal situation by the UK authorities. 147 From Akrich, it seems clear that with proper planning domestic immigration rules can be `planned around' using an exercise of fundamental freedom rights. This thinking is confirmed by the third case, Chen which appears to be a `pure' scheme with a series of steps each of which were part of the sequence of steps/transactions required in order to secure a right of residency in the UK for a third country national and to usurp the UK's immigration rules. The case demonstrates that `tax planning' can equally take place in an internal market context through the exercise of the freedoms as long as some careful advance planning goes into the process. It seems clear from the facts in the Chen case that considerable `planning' went into obtaining UK residency for the third country nationals involved. It is helpful to set out the facts in some length to be able to demonstrate the `steps' involved in the series of complex arrangements. The Chen case involved two Chinese nationals ± a husband and wife ± who worked for a business established in China. Mr. Chen travelled regularly to the UK. In May 2000, Mrs. Chen entered the UK when she was six months pregnant. She went to Belfast in July 2000 where her child, Catherine, was born in September Claiming citizenship under a Republic of Ireland nationality law, Catherine applied for an Irish passport because, at that time, anyone born on the island of Ireland was entitled to become an Irish citizen. Catherine was not entitled to British citizenship, even though she was born in Belfast. 148 Consequently, Catherine was issued with an Irish passport. The Court noted that: `It was common ground that Mrs. Chen took up residence on the island of Ireland in order to enable the child she was expecting to acquire Irish nationality and consequently, to enable her to acquire the right to reside...with her child in the UK'. 149 The Court confirmed first, that `a young child can 141 See Secretary of State for the Home Department and Akrich (`Akrich'), C-109/01. See para. 36 of the judgment where Mrs. Akrich is noted as having replied at one immigration interview that they intended to return to the UK because they had heard about EU rights, staying six months and then going back to the UK. She is reported as saying that she had been given that information by `solicitors and others in the same situation'! 142 See Chen, C-200/02 [2004] ECR I Akrich, para. 39 (emphasis added). 144 Akrich, para. 55 (citing Levin, para. 23). 145 Paraphrased from Akrich, paras. 55± Akrich, para Akrich, para. 61 third indent. 148 Belfast is located in Northern Ireland ± a part of the UK ± but also on the island of Ireland. 149 Chen, para. 12. EC TAX REVIEW 2007/1 25

14 take advantage of the rights of free movement and residence guaranteed by Community law' ± there was no minimum age requirement. 150 Secondly, as a citizen of the EU, Catherine was entitled to reside in any Member State subject to having sufficient resources to avoid becoming a burden on that state. As Catherine had both sickness insurance and sufficient resources provided by her family that was `sufficient' ± their origin/source did not matter. 151 The Court then dealt with the abuse of the Community freedom of movement arguments put forward by the UK which referred to the `arrangements' put in place by Mrs. Chen to secure Irish nationality for her child and, indirectly, a right of residence in the UK for herself as the child's primary carer. The ECJ examined the motives of the Chen family and noted that Mrs. Chen admitted that the purpose of her stay in the UK was to create this situation so that she and her child could access Community rights. 152 However, as the acquisition and loss of nationality was a matter for each Member State, and as the legality of Catherine's Irish nationality had never been challenged, it was not `permissible for a Member State to restrict the effects of the grant of nationality of another Member State'. Consequently, Catherine was entitled to reside in the UK as a Community national with sufficient resources to prevent her becoming a burden on the UK. Moreover, a refusal to allow the parent (whatever her nationality) and primary carer to reside with Catherine `would deprive the child's right of residence of any useful effect'. 153 Catherine was, accordingly, entitled to be accompanied by her primary carer who was also entitled to a right of residence in the UK for the duration of Catherine's residence. The Chen case demonstrates that as long as there is a genuine exercise of the fundamental freedoms, the motives behind the exercise of those freedoms will not necessarily jeopardize their use in order to circumvent national rules. It seems clear that the arrangements put in place in the Chen case were a `pure' scheme to achieve residency in the UK for Mrs. Chen. In other words, the exercise of the fundamental freedom or acquiring of the right of residency can be carried out for reasons which appear to be inappropriate to a Member State because the Member State's rules prevent the right of residency. However, all such Member State rules must be measured against the Community's Internal Market rules and the principle of proportionality. In Cadbury Schweppes, the Court followed this thinking by rejecting the motives of the UK parent company as being tax avoidance when it set up its subsidiaries in Ireland, even though the `arrangements' were put in place to obtain a tax advantage. Similarly, in Barbier, when the taxpayer took advantage of the favourable Dutch rules relating to splitting the legal and financial ownership of immovable property, for tax planning/mitigation/avoidance reasons. The motives behind the transactions and/or the use of the freedoms in both instances were to obtain tax advantages. Yet, the Court allowed such practices as long as the actual exercise of the fundamental freedom in question was properly exercised. The cases demonstrate that `tax planning' can take place using Community rights as long as it ensures that the objective of the rules in question are met and as long as there is a genuine activity/establishment/capital movement/service/etc. carried out, and `wholly artificial arrangement' situations are avoided Origin and host Cadbury Schweppes is the latest in the line of `origin state' cases decided by the Court. The judgment shows that the `Migrant/Non-migrant' test 154 continues to be applied by the Court in determining whether there is different treatment by the origin state of a resident of that Member State, exercising a Community freedom, compared with a comparable person who carries out a similar operation domestically. Cadbury Schweppes extends the Court's thinking in this area somewhat as the UK's CFC rules did not apply to establishment of subsidiaries in all Member States ± the rules were only applicable to states where there was a significant lower rate of taxation than the UK's rate of taxation. Consequently, the Court equates the establishment of subsidiaries in other Member States (with rates of taxation similar to the UK) to the establishment of subsidiaries in the UK Host The origin/host distinction in the Court's case law can be traced back in the tax area to two of its earliest judgments: Avoir Fiscal 156 and Daily Mail. 157 In Avoir Fiscal, the Court examined a host state situation in the context of the freedom of establishment and determined that: `Article [43] is thus intended to ensure that all nationals of Member States who establish themselves in another Member State, even if that establishment is only secondary, for the purpose of pursuing activities there as a self-employed person, receive the same treatment as nationals of that state and it prohibits, as a restriction on freedom of establishment, any discrimination on grounds of nationality resulting from the legislation of the Member State'. 158 The Court therefore examined a `host state's' rules and considered whether Community nationals (companies) from Member States other than the host-state (France) were receiving the same treatment, when they exercised their freedom of establishment and set up 150 Chen, para Chen, paras. 26 et seq. 152 Chen, para Chen, para See the discussion below. 155 See Cadbury Schweppes, paras. 44± See Commission v France (`Avoir Fiscal'), 270/83 [1986] ECR See The Queen v HM Treasury and Commissioners of Inland Revenue, ex parte Daily Mail and General Trust plc, 81/87 [1988] ECR Avoir Fiscal, para. 14. Article 43 was formerly Art. 52 at the time of the judgment. 26 EC TAX REVIEW 2007/1

15 branches of their insurance companies (resident in other Member States) in France, as French companies. Under Arts. 43 and 48 of the EC Treaty, such companies were entitled to be treated in France no worse than French insurance companies whenever they were in a `comparable situation'. 159 The Court found that the French branches of such non-resident companies, were in a comparable situation to French companies because French tax law did not distinguish between the branches and French companies when it came to determining their income liable to French corporation tax. 160 By taxing their profits in the same way, France had admitted that there was no objective difference between the establishments. Consequently, it would be discriminatory to grant a tax advantage (the tax credit) to French companies and not to companies of other Member States with branches in France. 161 In other words, the companies resident in other Member States with branches in France were entitled to `national treatment'. A more detailed explanation of the obligations of the `host-state' in relation to the exercise of the fundamental freedoms was given by the Court in Futura, 162 where the Court made it clear that the `hoststate's' obligations went beyond `national treatment'. In Futura, it will be recalled that a French company set up a branch in Luxembourg which incurred losses. In order to obtain loss relief, Luxembourg rules provided that the losses must have an economic link with Luxembourg territory; and a set of accounts had to be kept at the Luxembourg branch which complied with Luxembourg accounting rules. The Court, first of all, carried out a `discrimination analysis' and concluded that there was no discrimination because Luxembourg companies and French companies with branches in Luxembourg were treated alike ± in order to get loss relief both types of establishment had to demonstrate that the losses were related to Luxembourg activities. 163 Next, the Court conducted a `restriction analysis' concerning the requirement that a set of Luxembourg accounts had to be maintained at the branch in order for the loss relief to be considered. The Court found that `such a condition may constitute a restriction' 164 on the freedom of establishment which is in principle prohibited. 165 When it examined the justifications put forward by Luxembourg, the Court accepted that the losses had to be proved to the satisfaction of the Luxembourg tax authorities but that it was disproportionate to require the French company with the Luxembourg branch to maintain a second set of accounts in Luxembourg. It was sufficient for the French company to demonstrate the amount of the losses to the Luxembourg authorities ± a set of Luxembourg accounts was not necessary and loss relief rules containing such a condition were incompatible with the freedom of establishment. The obligations of the host sate were aptly summarized in the Opinion of Advocate-General Lenz in Futura, when he said: `as long as there is no discrimination against non-resident companies and no restriction on the freedom of establishment, it is for the Member State to choose the way in which losses are to be determined'. 166 The obligations of the host state are therefore nondiscrimination of comparable situations when persons from other Member States exercise their fundamental freedom rights in the host state; and non-restriction of a non-resident exercising a fundamental freedom on its territory unless there is a proportionate justification for the restrictive treatment Origin In Daily Mail, the Court encountered the freedom of establishment provisions of the EC Treaty and noted that they also prohibited the origin-member State `from hindering the establishment in another Member State of one of its nationals or of a company incorporated under its legislation'. 167 It took another eleven years or so before the Court pronounced on a similar origin state case in a tax setting when it gave its judgment in Terhoeve. 168 There, a Dutch national and resident was adversely affected when he exercised his right of free movement of workers. As he had worked for part of the tax year in another Member State he was denied the benefit of a `ceiling' or maximum limit on his social security contributions. Advocate-General Ruiz-Jarabo Colomber postulated 169 that this amounted to a difference in treatment compared with Dutch workers who did not exercise their free movement of worker rights (and earned all their income for the tax year in the Netherlands ± these Dutch residents benefited from a `ceiling' in the amount of social security taxes that were payable). The Court accepted this `different treatment' comparison in its judgment. The relevant paragraph is worth quoting because it establishes the foundations for the `migrant/non-migrant' test that the Court continues to apply (including in Cadbury Schweppes) in relation to 159 Avoir Fiscal, para Avoir Fiscal, para Avoir Fiscal, para See Futura Participations, C-250/95 [1997] ECR I See Futura, paras. 20± See Futura, para See Futura, para. 26 (citing, as an example, Gebhard, para. 37). 166 See the Opinion of Advocate-General Lenz in Futura, para Daily Mail, para See FC Terhoeve v Inspecteur van de Belastingdienst, C-18/95 [1999] ECR I See the Opinion of Advocate-General Ruiz-Jarabo Colomber in Terhoeve, para. 53. In para. 56, the Advocate-General cites the judgment of the Court in Kraus: `Articles 48 and 52 preclude any national measure... where that measure, even though it is applicable without discrimination on grounds of nationality, is liable to hamper, or to render less attractive the exercise by Community nationals, including those of the Member State which enacted the measure, of fundamental freedoms guaranteed by the Treaty. The situation would be different only if such a measure pursued a legitimate objective compatible with the Treaty and was justified by pressing reasons of public interest... It would however also be necessary in such a case for application of the national rules in question to be appropriate for ensuring attainment of the objective they pursue and not to go beyond what is necessary for that purpose'. See Kraus, C-19/92 [1993] ECR I-1663, para. 32. EC TAX REVIEW 2007/1 27

16 origin-member States whose rules restrict the exercise of the fundamental freedoms of their own residents (in Terhoeve, the free movement of workers was at stake): `A national of a Member State could be deterred from leaving the Member State in which he resides in order to pursue an activity as an employed person, for the purposes of the Treaty, in the territory of another Member State if he were required to pay greater social contributions than if he continued to reside in the same Member State throughout the year, without thereby being entitled to additional social benefits such as to compensate for that increase' `Migrant/non-migrant test' The comparison used by the Court for the purpose of determining whether the different treatment is a restriction of the freedoms is clear from its Terhoeve judgment ± the person who exercises the freedom (the `migrant') is compared with the person who stays at home (the `non-migrant'). Both are in a comparable situation ± in Terhoeve, the Court pointed out that the payment of the extra social security contributions relating to the employment income in the other Member State did not provide any increased social security benefits. 171 Citing Bosman, 172 the Court said, `Provisions which preclude or deter a national of a Member State from leaving his country of origin in order to exercise his right to freedom of movement therefore constitute an obstacle to that freedom even if they apply without regard to the nationality of the workers concerned'. 173 In Eurowings, the Court applied a similar comparison in the area of free movement of services when German legislation provided for additional taxation of leasing services acquired in a Member State other than Germany ± in other words, a German company which leased goods from an Irish company was treated less favourably from a tax point of view than a comparable German company that leased similar goods from a German resident company. The Court noted that: `The legislation at issue... contains tax rules which are less favourable to German undertakings leasing goods from lessors established in other Member States, who may thus be dissuaded from having recourse to such lessors any legislation of a Member State which... reserves a fiscal advantage to the majority of undertakings which lease goods from lessors established in that State [the origin state] whilst depriving those leasing from lessors established in another Member State of such an advantage gives rise to a difference of treatment based on the place of establishment of the provider of the services, which is prohibited by Article [49] of the Treaty'. 175 The Court developed the `migrant/non-migrant test' further in Baars 176 where the freedom of establishment was at stake. Repeating its Daily Mail mantra in relation to hindering the freedom of establishment by origin state rules, the Court pointed out that `Article [43] of the Treaty prohibits a Member State from hindering the establishment in another Member State of nationals of Member States residing on its territory'. 177 The phrase `nationals of Member States residing on its territory' is interesting because of the relationship between host and origin states. In relation to its nationals, clearly the Member State's rules are `origin' state rules; but from the perspective of nationals of other Member States established in its territory, that same Member State is a `host' state for such persons normally because they have generally moved from another Member State and established themselves there. If such persons decide to exercise their fundamental freedom rights in another Member State and they are hindered from so doing, the judgment in Baars makes it clear that they are entitled to the same treatment as that state's own nationals ± this is a clarification of the `migrant/non-migrant test' rather than an extension because the rules involved from an origin state perspective are usually `exit' rules of one kind or another that hinder, dissuade, deter, discourage, or make less attractive the exercise of a fundamental freedom. 178 In relation to the free movement of capital, the Court applied the `migrant/non-migrant test' in Verkooijen 179 where a Dutch resident was denied a dividend tax exemption/relief because he received his dividend from a Belgian company and not a Dutch company: the test was applied to deal with the situation of a Dutch resident who had investments in another Member State (the so-called `migrant' because his capital migrated across the border to another Member State) and lost a tax advantage compared to a similar Dutch resident investor who invested capital in a Dutch company (the `non-migrant' in these circumstances relating to capital movement). The Court reiterated this thinking in relation to the new free movement of capital provisions of the EC Treaty in Manninen where a Finnish investor who had invested capital in a Swedish company was denied a tax credit under Finnish rules (origin state) compared with Finnish investors who invested in Finnish companies, who received the tax credit ± the Finnish resident who invested capital cross-border (the `migrant', in the sense of the migration of capital to another Member State) was treated differently (without proportionate justification) than a similar Finnish resident investor who invested in a Finnish company (the `nonmigrant'). 170 Terhoeve, para Terhoeve, para See Bosman, C-415/93 [1995] ECR I-4921, para Terhoeve, para Eurowings, para Eurowings, para. 40. At the time of the judgment Art. 49 of the EC Treaty was numbered as Art See Baars, C-251/98 [2000] ECR I Baars, para Perhaps a good contrast is seen in Halliburton where the closing down of a branch in the Netherlands was seen as a host State situation requiring `national treatment'. See Halliburton, C-1/93 [1994] ECR I See Verkooijen, C-35/98 [2000] ECR I EC TAX REVIEW 2007/1

17 Finally, the Court has also applied the `migrant/ non-migrant' test in the relatively new area of EU citizenship. In Pusa, a Finnish resident left his origin state to reside in Spain. Unfortunately, by doing so he fell foul of Finnish tax rules that failed to properly take into account that he was now also paying tax in Spain on his pension. The Court noted that: `it would be incompatible with the right of freedom of movement were a citizen, in the Member State of which he is a national, to receive treatment less favourable than he would enjoy if he had not availed himself of the opportunities offered by the Treaty in relation to freedom of movement'. 180 Furthermore the Court went on to point out that: `National legislation which places at a disadvantage certain of its nationals simply because they have exercised their freedom to move and to reside in another Member State would give rise to inequality of treatment, contrary to the principles which underpin the status of citizen of the Union, that is, the guarantee of the same treatment in law in the exercise of the citizen's freedom to move'. 181 In other words, the Finnish resident who moves to exercise EU citizenship rights of movement to another Member State cannot be treated worse than the Finnish resident who stays in Finland unless some justification is shown that is proportionate. Here, the `migrant/non-migrant test' is extended into the sphere of EU citizenship. Consequently, the test has been regularly used by the Court in origin state cases. More recently, the test has been applied in relation to `exit' taxes in De Lasteyrie du Saillant, 182 in Marks and Spencer 183 in relation to establishment and crossborder loss relief rules, in Keller Holding 184 in relation to establishment of indirect subsidiaries and finance expenses, and in Cadbury Schweppes, again in relation to establishment and the UK's CFC rules. In Cadbury Schweppes, the Court found a difference in the tax treatment of two comparable UK parent companies depending on whether they established their subsidiary in another Member State where the CFC rules applied or whether they established their subsidiary in the UK (or in another Member State where the CFC rules did not apply). 185 The Court noted that the `difference in treatment creates a tax disadvantage for the resident company to which the legislation on CFCs is applicable'. The Court is therefore comparing the treatment of the UK parent company that establishes in Ireland (where CFC rules apply ± the `migrant') with the similar UK parent company that establishes a subsidiary in the UK (the `non-migrant'). Subsidiaries established in other Member States where the UK CFC rules are not applicable are equated by the Court, in this situation, to UK subsidiaries as in both situations the CFC rules have no application. Consequently, the Court continues to apply and develop the `migrant/non-migrant test' when dealing with origin state rules which hinder, discourage, deter, or render less attractive the exercise of the Community's fundamental freedoms and citizenship rights Forum shopping The Cadbury Scweppes judgment confirms that `forum shopping and `rule shopping' are legitimate within an internal market provided that fraud and wholly artificial arrangements designed to circumvent national laws are not involved. The case makes it clear that as competence in relation to direct tax matters remains with the Member States, this means that Member States can set their own tax rates: this was a 10 per cent corporation tax rate in the IFSC. 186 Consequently, the rate of taxation chosen by the Member State can be a 1 per cent rate or even a zero rate. As long as the establishment is actual and genuine, then the lower tax rates can be accessed in that Member State by Community nationals resident in other Member States through the exercise of Community rights. Thus, in Cadbury Schweppes, the UK parent company was able to access the privileged tax rates of the IFSC regime through the establishment of a subsidiary in Ireland. Whilst, from a UK perspective this may have had the appearance or effect of tax avoidance, the Court is satisfied that where the establishment is real and genuine, such a subsidiary is entitled to benefit from the lower tax rates. This requires an examination of the decision of the UK parent company to establish in the IFSC ± if this is an actual and genuine exercise of the freedom of establishment in another Member State, then the Court is saying that the UK's CFC rules can only apply if there are wholly artificial arrangements designed to circumvent UK tax laws. In other circumstances, the UK's CFC rules are incompatible with the freedom of establishment because they are a disproportionate response to the situation which looks at the cross-border transactions purely from a protectionist perspective instead of a single market perspective ± there is no tax avoidance if the subsidiary is taxed in Ireland ± just as there would be no tax 180 Pusa, para Pusa, para See De Lasteyrie du Saillant, C-9/02, para Marks and Spencer, paras. 33± See Case C-471/04 Finanzamt Offenbach am Main-Land v Keller Holding GmbH, [2006] ECR I-2107, paras. 33±34 (`Keller Holding'). Keller Holding is a very clear example of the relevant comparator ± both parent companies involved in the comparison received dividends from their indirect subsidiary on a `tax-free' basis (although via slightly different routes); but it was only the parent company which had exercised its freedom of establishment rights that was disadvantaged when it came to the deduction of expenses related to the indirect subsidiary. The cross-border investment was denied a deduction in circumstances where both parent companies were comparable ± a parent company establishing an indirect subsidiary in another Member State (the `migrant') might be deterred from establishing such an indirect subsidiary in other Member States because establishment in the origin state (`non-migrant') would have attracted a tax deduction/advantage denied to it because its activity took place cross-border. The judgments in Keller Holding and Cadbury Schweppes demonstrate that post-marks and Spencer case law of the Court in relation to origin state situations has not changed and the `migrant/non-migrant test' holds good. 185 Cadbury Schweppes, paras. 44± This is of course subject to the state aid rules of the EC Treaty ± see Art. 87 et seq. EC TAX REVIEW 2007/1 29

18 avoidance if the subsidiary were established in France and higher tax rates were imposed on the subsidiary there, compared with the rates in the UK; there is simply a reduction in UK tax revenue `Establishment' It may be interesting to reconcile (or at least attempt to reconcile) the Cadbury Schweppes judgment with the Segers/Centros/Inspire Art line of cases 187 where no genuine activity took place in the State of establishment of the subsidiary. In Cadbury Schweppes, the Court indicated that the taxation provided by the UK's CFC rules must be excluded where, despite the existence of tax mitigation motives, the incorporation of the CFC reflects economic reality; 188 and it goes on to discuss what this means: there must be `an actual establishment intended to carry on genuine economic activities in the host Member State'. 189 In other words, a physical establishment of some kind must exist in terms of premises, staff and equipment. The Court continues: `If checking those factors leads to the finding that the CFC is a fictitious establishment not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement. That could be so in particular in the case of a ``letterbox'' or ``front'' subsidiary'. 190 In Centros, 191 a Danish resident couple incorporated a company in the UK with the intention of opening a branch of that company in Denmark. This enabled them evade the minimum share capital rules for Danish companies. As the company never traded in the UK, the Danish authorities refused to register the branch (even though they would have done so if it had conducted some activity in the UK). The Court noted that it was immaterial that the UK company was only established in the UK so that a branch could be set up in Denmark to conduct its entire business there. 192 Similarly, the motive ± avoiding the Danish minimum share capital rules ± behind the formation of the company in the UK was irrelevant. That fact alone did not mean that the formation by the UK company of a branch in Denmark was not covered by the freedom of establishment. 193 The Court clarified the two issues in the case: (i) was the UK company's formation of a branch in Denmark covered by the freedom of establishment? (answer is yes) (ii) can a Member State adopt measures to prevent its nationals from evading national laws by using Community law rights? (answer is yes, subject to compliance with Community law and the principle of proportionality). The Court stated that `the fact that a national of a Member State who wishes to set up a company chooses to form it in the Member State whose rules of company law seem to him the least restrictive and to set up branches in other Member States cannot, in itself, constitute an abuse of the right of establishment'. 194 However, this is a totally separate issue from whether a Member State can take appropriate measures to prevent or penalize fraud: `either in relation to the company itself... or in relation to its members, where it has been established that they are in fact attempting, by means of the formation of the company, to evade their obligations towards private or public creditors.... In any event, combating fraud cannot justify a practice of refusing to register a branch of a company which has its registered office in another Member State'. 195 The Court follows this reasoning in Inspire Art where a UK company was formed with a branch in the Netherlands by a Dutch resident. Inspire Art traded exclusively in the Netherlands. The Dutch rules provided for additional registration formalities because the branch was that of a foreign company requiring the UK company to comply with requirements similar to the establishment of a subsidiary in the Netherlands. The Court found that this requirement was a restriction of the freedom of establishment 196 and concluded that: `The reasons for which the company was formed in that other Member State, and the fact that it carries on its activities exclusively or almost exclusively in the Member State of establishment, do not deprive it of the right to invoke the freedom of establishment guaranteed by the Treaty, save where abuse is established on a case by case basis'. 197 Reconciling the Centros line of case law, therefore, seems possible. The Court is satisfied in Segers, Centros and Inspire Art that there is no fraud or abuse involved and there are real activities going on ± in the state where the secondary establishment is operating. For the Court, this is sufficient to demonstrate that a real and genuine business activity is being carried on in relation to the exercise of the freedom of establishment. The fact that no business activity takes place in the Member State of incorporation is irrelevant because the `establishment' of the branch/secondary establishment is clearly a genuine operation. The Court's jurisprudence in the free movement of services area confirms that reasoning. In VT4, 198 a 187 See Segers, 79/85 [1986] ECR 2375; Centros, C-212/97 [1999] ECR I-1459 and Kamer van Koophandel en Fabrieken voor Amsterdam v Inspire Art Ltd, C-167/01 [2003] ECR I Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para See Centros, C-212/ Centros, para Centros, para Centros, para. 27. The Court had already decided in Segers that a valid establishment could exist even if the company carried on no business in the state of incorporation. See Segers, 79/85 [1986] ECR 2375 para Centros, para Inspire Art, para Inspire Art, para See VT4, C-56/96 [1997] ECR I EC TAX REVIEW 2007/1

19 broadcasting case, a UK company was incorporated as a wholly owned subsidiary of a Luxembourg broadcasting company with a view to broadcasting satellite television programmes from the UK to the Flemish region of Belgium. The Court confirmed that in relation to the freedom to provide services the mere fact that all its broadcasts from the UK were aimed at the Flemish market did not mean that the company was not validly established in the UK. Moreover, the Court determined that: `The Treaty does not prohibit an undertaking from exercising the freedom to provide services if it does not offer services in the Member State in which it is established'. 199 Further clarification is provided by Advocate-General Tizzano in his Joined Opinion in the Open Skies cases, where he pointed out that the right of establishment still applied even if the business of the establishment involved services exclusively provided to third countries: `that by virtue of Article [43] of the Treaty Member States are required to accord national treatment to the companies of other Member States established in their territory and this is so whether they propose to operate air services solely within the Member State in question or to other Member States, or whether they propose to operate such services also, or exclusively, to third countries... Member State could not, without being in breach of Article [43], allow only its national companies, and not those established in its territory but controlled by nationals of other Member States, to provide consultancy services to Japanese companies, to market products in Canada, to organise holidays in the Caribbean countries or to provide express courier services to Australia, and so forth'. 200 The separation of the issues of abuse and exercise of the freedoms is important ± challenging abuse is clearly within the powers of the Member States. However, the mere exercise of either the freedom of establishment by the incorporation of a company in one particular state with a subsequent opening of a branch in another Member State; or the establishment of a company in one Member State which provides services wholly in another Member State; these facts alone do not represent abuse as the Court in Cadbury Schweppes agreed. 201 In all of the situations described in the Centros line of case law, there were genuine activities being undertaken. As such the suggestion in Cadbury Schweppes that the CFC must carry on `genuine economic activities in the host Member State' 202 (the state of incorporation of the company) cannot be interpreted to mean that `all' activities must be carried on there. The fact that in VT4 the UK company provided all its services from the UK to Belgium by broadcasting satellite signals/providing services cross-border does not imply that the establishment of the company in the UK was `fictitious' 203 or a `wholly artificial arrangement' ± it was still a UK company providing genuine services and undertaking genuine business activities as a UK resident company. Similarly, in Segers, Centros, and Inspire Art, the UK companies were still taxable entities in the UK under UK tax rules with branches of activity in the case of Centros and Inspire Art in other Member States ± but these were still UK companies carrying on economic activities ± even though the residence of those companies may, under the UK domestic rules or under the respective UK DTCs with Denmark and the Netherlands respectively have been allocated to those states Justification Need to ensure that the balance in the allocation of taxing rights between Member States is maintained. The Court first accepted this justification in Marks and Spencer, in the context of the UK's group relief rules which were not extended in the case of cross-border subsidiaries of UK parent companies whereas group relief was granted in relation to subsidiaries established in the UK. Consequently, this different treatment had to be justified because freedom of establishment was restricted. One ground of justification put forward by the UK can be termed the `symmetry' argument: there was a need to ensure that the state which normally taxed the profits of the subsidiary should also provide the relief for losses as otherwise the balance put in place by Member States when they agreed their DTCs and international taxation rules would be upset. The Court explained that companies should not have this option ± the state of establishment should deal with the loss relief relating to subsidiaries established there because they are the state that will normally tax the profits of that subsidiary. This allows the Member States to plan their taxation systems on the basis that no taxation of the foreign subsidiary means, in effect, no requirement to give loss relief cross-border. The Court extracted this line of reasoning from its `hospital' or health care case law 204 where a similar jurisprudence had developed to prevent patients from one Member State going to other Member States to receive public heath care services/treatment without some form of prior authorisation procedure. To allow patients to simply move between Member States at 199 VT4, para See para. 124 of Advocate-General Tizzano's Joined Opinion in `Open Skies'. See Commission v UK and others, C-466/98 [2002] ECR I-9427 (`Open Skies'). Similarly, the Court rejected a German argument that freedom of establishment was limited to crossborder activities within the Community (see para. 142 of the judgment in Commission v Germany (Open Skies)) saying, `Article 52 of the Treaty is in particular properly applicable to airline companies established in a Member State which supply air transport services between a Member State and a non-member country. All companies established in a Member State within the meaning of Article 52 of the Treaty are covered by that provision, even if their business in that State consists of services directed to non-member countries'. See para. 146 of the judgment in Commission v Germany (Open Skies), C-476/98 [2002] ECR I Note: Art. 43 of the EC Treaty was numbered Art. 52 of the EC Treaty at the time of the Open Skies cases. 201 Cadbury Schweppes, para Cadbury Schweppes, para Cadbury Schweppes, para See the Opinion of the Advocate-General in Marks and Spencer ± the Advocate-General laid the groundwork for this justification. EC TAX REVIEW 2007/1 31

20 their option would cause untold budgetary and planning problems for long-term health care planning; similarly, in the tax arena, the Court saw it as unfair on Member States who have planned their budgets on the basis of the non-taxation of foreign subsidiaries, to have to provide loss relief for losses incurred by those subsidiaries. The Court accepted this possible justification 205 of the fundamental freedoms and coined the defence ± the need to ensure that the balance in the allocation of taxing rights between Member States is maintained. This defence or justification was necessary as otherwise the taxable basis would be increased in one state and reduced in the other to the extent that losses were transferred between the two states involved. 206 However, although the UK group relief rules ensured that this objective was achieved (because the group relief was not granted cross-border, therefore, losses could not be transferred from the state of establishment to the state of the parent company), the Court next had to consider whether such rules were necessary to achieve the objective of the legislation ± in other words, whether a total ban on loss relief crossborder was necessary or whether it had to be permitted in some circumstances. The Court replied that in certain circumstances, where loss relief could not be obtained for the subsidiary's losses in the state of establishment, then, in an internal market context the origin state should provide relief for such losses because it provided this type of relief for its resident companies which operated subsidiaries in the UK. Comparable UK resident parent companies were treated differently depending on the location of their subsidiaries ± if the subsidiaries were established in the UK, loss relief was granted; if the subsidiaries were established in other Member States ± the group relief rules did not apply. In such circumstances, the Court determined there was a restriction on the freedom of establishment which required justification. 207 The Court in Cadbury Schweppes noted that the practices being targeted 208 by the UK's CFC rules were similar to the transfers of losses discussed in the Marks and Spencer decision, except that in this situation these were profit movements out of one jurisdiction into a lower tax jurisdiction. CFC rules therefore achieved their purpose because they prevented `practices which have no purpose other than to escape tax normally due on the profits generated by activities carried on in national territory'. 209 As the Advocate-General made clear: `The conduct objected to is therefore for a parent company to reduce its taxable profits by paying its subsidiary for services, relying on the fact that the subsidiary's profits will be taxed in the host State at a much lower rate than that in effect in the State of origin.... By adding the profits made by the CFC to the parent company's tax base, there is no doubt that the legislation in question cancels the effects of such a practice'. 210 However, the question then remained, applying the Gebhard formula 211 discussed above, whether the CFC rules went beyond what was necessary to achieve that purpose. Clearly, as the Advocate-General pointed out, centralising treasury services in a low-tax Member State `does not prove the existence of a wholly artificial arrangement'. 212 Consequently, the outcome of the Cadbury Schweppes case will depend on the findings of the national court and the evidence offered by the parent company to rebut the presumption of `wholly artificial arrangements', but it seems that the UK's CFC rules are in any event disproportionate and will need to be amended Final thoughts The Cadbury Schweppes is a landmark decision for all EU/EEA states who have CFC rules. These will now need to be re-examined to ensure compatibility with Community law. 214 The confirmation that `forum shopping' and `rule shopping' is acceptable, generally speaking, has an impact in many areas of direct taxation including the DTC network of the EEA states. The fact that the Court has confirmed that Member States can offer different rates of taxation, and much lower rates than other Member States, means that zero rates are also acceptable in an internal market context because the Member States are competing for `establishments' ± not only establishments of companies from other Member States but, equally, for the formation of holding companies of third country nationals. Once such third country owned companies are properly incorporated on the territory of any EU/ EEA state, such EU/EEA companies have the right of establishment provided they retain a `real and continuous link' with the economy of a Member State. 215 Cadbury Schweppes is of further significance because it confirms the `migrant/non-migrant test' in relation to origin states and provides considerable guidance on the concept of `establishment'. But perhaps, the most important aspect of the Cadbury Schweppes judgment is the road-map it provides for tax planners and tax mitigation practices in general. The concept of `wholly artificial arrangements' is also analysed at some depth. In all, the judgment is a clear win for the taxpayer company, subject to proof that the IFSC arrangements 205 Marks and Spencer, paras. 43± Marks and Spencer, para Marks and Spencer, para Cadbury Schweppes, para. 48 refers to `the artificial transfer' of profits `from the Member State in which they are made to a lowtax State by means of the establishment of a subsidiary'. 209 Cadbury Schweppes, para See paras. 124 and 125 of the Opinion in Cadbury Schweppes. 211 See Gebhard, C-55/94 [1995] ECR I-4165, para See para. 148 of the Opinion in Cadbury Schweppes. 213 Cadbury Schweppes, para For reasons of brevity, any discussion of the next stage of the Cadbury Schweppes litigation, or of the CFC GLO and the Vodafone 2 litigation, has been postponed until a later article. Clearly, from the judgment of the Court, it seems highly likely that the UK's CFC rules, in the opinion of this author, will have to be radically overhauled as the `motive test' is not limited to `wholly artificial arrangements'. 215 See Uberseering, C-208/00 [2002] ECR I-9919, para EC TAX REVIEW 2007/1