The European Court of Justice Court (ECJ) ruled against the UK on 12 September, deciding that the country's rules on controlled foreign corporations (CFCs), was limited to wholly artificial companies with no real economic activity. The UK's rules allows the UK treasury to tax foreign subsidiaries in other EU states with lower rates.
The ruling provides backbone for the European Commission's attempt to push member states to agree on a common minimum corporate tax rate for EU companies.
Such a harmonisation could serve to take the tax equation out of decisions about where to locate a company's manufacturing plants and treasury activities. It could also push countries such as the UK, France and Germany to lower their relatively high rates.
Cadbury would have been forced to pay millions of euros in back taxes if the court had ruled against the company. The ruling relates to the UK's bid to tax Cadbury's two subsidiaries in Ireland, Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI).
Cadbury established its treasury operations in Ireland's International Financial Services Centre (IFSC) in Dublin, where in 1996 the tax rate was 10 per cent. The two companies are responsible for raising finance and providing that finance to the Cadbury group.
A UK court had previously ruled that Cadbury established the subsidiaries in Dublin solely to take advantage of the favourable tax regime and escape the UK's substantially higher rate.
In 2000 the Commissioners of Inland Revenue claimed corporation tax from Cadbury Schweppes of £8,638,633. on the profits made by CSTI in 1996.
Cadbury Schweppes appealed before the Special Commissioners of Income Tax, maintaining that the CFC legislation was contrary to EU law, in particular those directives that deal with freedom of establishment. The Special Commissioners asked the Court of Justice whether community law precluded rules such as the CFC legislation.
The UK's CFC rule makes the resident company pay the difference between the tax paid in the foreign country and the tax which would have been paid if the company had been resident in the UK. It is designed to stop UK-based companies from transfering profits from its EU subsidiaries to the member with the lowest corporate tax rate.
Under current UK tax legislation, the profits of a foreign company in which a UK resident company owns a holding of more than 50 per cent are attributed to the resident company and subjected to tax in the UK. The tax is assessed when the corporation tax in the foreign country is less than three quarters of the rate applicable in the UK.
The resident company receives a tax credit for the tax paid by the CFC. There are a number of exceptions granted under legislation. Companies are exempted from the rule in cases where the CFC distributes 90 per cent of its profits to the resident company or where the 'motive test' is satisfied.
In order to obtain an exception under the 'motive test', a company must show that neither the main purpose of the transactions which gave rise to the profits of the CFC nor the main reason for the CFC's existence was to achieve a reduction in UK tax by means of the diversion of profits.
In their decision the ECJ judges noted that companies or persons cannot improperly or fraudulently take advantage of provisions of EU law to escape taxes
"However, 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 an abuse of the freedom of establishment," they ruled. "Therefore the fact that Cadbury Schweppes decided to establish CSTS and CSTI in Dublin for the avowed purpose of benefiting from a favourable tax regime does not in itself constitute abuse and does not prevent Cadbury Schweppes from relying on community law."
The judges noted that the CFC legislation involves a difference in the treatment of resident companies on the basis of the level of taxation imposed on the company in which they have a controlling holding.
"That difference in treatment creates a tax disadvantage for the resident company to which the CFC legislation is applicable," they wrote. "The CFC legislation therefore constitutes a restriction on freedom of establishment within the meaning of community law."
They also noted that the application of the CFC legislation might be justifiable in cases where it specifically relates to wholly artificial arrangements aimed solely at escaping national tax normally due and where it does not go beyond what is necessary to achieve that purpose.
The fact that Cadbury intended to obtain tax relief by establishing the CFC in Dublin is not sufficient for the UK tax authorities to justify their decision that the incorporation was an 'artificial arrangement' under the 'motive' test.
"In order to find that there is such an arrangement there must be, in addition to a subjective element, objective and ascertainable circumstances produced by the resident company with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment, showing that the incorporation of a CFC does not reflect economic reality, that is to say it is not an actual establishment intended to carry on genuine economic activities in the host member state," the court stated.
The UK's tax officials would have to determine whether the motive test lends itself to an interpretation which takes account of such objective criteria, the judges stated. In such cases, the UK's CFC legislation would be regarded as being compatible with EU law, they stated.
"On the other hand, if the criteria on which that test is based mean that a resident company comes within the scope of application of that legislation, despite the absence of objective evidence such as to indicate the existence of a wholly artificial arrangement, the legislation would be contrary to community law," they ruled.
In July 2004, the European Commission proposed setting a EU-wide common tax base. The proposal was discussed at that year's meeting of EU finance ministers. On 5 April 2006 the Commission issued an update on its proposals for a common consolidated corporate tax base for the bloc.