OVER THE LAST 12 months there have been some significant cases heard before the European Court of Justice (ECJ), which could have a major impact on European Union (EU) member state tax regimes. The EU also represents an important market for companies, in particular the markets and resources in the new accession countries, including Bulgaria and Romania, which are due to join the EU in 2007. Companies, when planning investment strategies, need to keep abreast of these developments in tax regimes in order to ensure that shareholder value is maximised.
The Channel Islands are not part of the EU. Therefore, should Channel Island companies be interested in what is happening in the EU? This article considers the subject of EU developments and their impact on the Channel Islands.
It is worth reminding ourselves of EU taxation policy in order to appreciate the developments that are currently on the EU tax agenda. The EU has stated in its document “Taxation Policy in the European Union” that whilst its role is supplementary to the national tax systems, “its aim is not to standardise the national systems of compulsory taxes and contributions, but simply to ensure that they are compatible not only with each other, but also with the aims of the Treaty establishing the European Community”.
Underpinning this overriding principle are the concepts provided in the Treaty of Free Movement of Goods, Persons, Services and Capital and the Right of Establishment of Individuals and Companies.
In essence, the EU provides the framework for member country tax legislation and aims to ensure that this legislation does not impede the concepts signed up to above. Where there has been confl ict between EU law and EU member law, these disputes, in a number of cases, have been pursued through the ECJ.
EU member states are trying to balance compliance with EU legislation with national anti-avoidance laws, to prevent the loss of national tax revenues.
There have been a number of tax cases heard before the ECJ, however, the key recent cases that have shaped, or are likely to shape EU member legislation, are Marks & Spencer – Group Relief of Losses; Halifax – VAT avoidance; and Cadbury Schweppes – Controlled Foreign Companies.
In addition, the EU has stated that a common consolidated corporation tax base(CCCTB) would provide a significant step to reducing the tax obstacles and compliancecosts of doing business in the EU.
Marks & Spencer
The case involved Marks & Spencer (M&S) in the UK, claiming group relief for losses incurred by its European subsidiaries. M&S argued that by not being able to set-off losses in its European subsidiaries against the UK parent’s profits, this represented an infringement on its right to establish a subsidiary in another EU member state. The ECJ agreed the principle of the M&S case, although the losses available for set off in the EU were restricted to the extent that the subsidiary had first exhausted all other possibilities of using the losses in the member state in which it was resident.
The Halifax case concerned artifi cial tax avoidance schemes. Halifax wished to avoid suffering non-recoverable VAT on the construction of call centres. Halifax, through its subsidiaries, contracted for the call centres to be built for one of its subsidiaries outside of its VAT group. The effect of the transactions was to reclaim VAT which the bank would not normally be able to do, due to its exempt status.
The ECJ ruled that where a taxpayer enters into transactions that are changed from what they might have been in order to avoid irrecoverable VAT, a tax authority may be entitled to reverse these transactions to what they might have been if the transactions had not taken place. The reason for this was that the principles of the Sixth Directive precluded abusive practice.
In the Cadbury case, the Group had two indirect holdings in Irish resident subsidiaries operating in the International Financial Services Centre in Dublin, which attracted an Irish tax rate of 10 per cent. The purpose of the companies was to raise finance and provide that finance to other subsidiaries in the Cadbury Group. The UK tax authorities assessed a UK company of Cadbury under the UK Controlled Foreign Company (UK CFC) rules, on a deemed distribution.
The ECJ delivered their judgement on the case on 12 September 2006. It was determined that the UK CFC rules represented a restriction on the freedom of establishment. The court looked at the exemptions which would prevent the UK CFC rules applying, specifically the motive test. The conclusion reached was that the motive test would be compliant with EU community law, if its effect was only to tax companies that had not been set up for genuine commercial reasons.
Common Consolidated Corporate
Tax Base (CCCTB)
Since 2000, the EU has been initially discussing and latterly working towards a common basis of taxation in the EU. The objectives of the working party looking at the CCCTB are as listed.
The EU is, in essence, seeking to establish a tax base that uses the same generally accepted accounting principle (e.g. IAS) as the starting point for calculating the tax payable. It must ensure that the scope of taxable income is consistent across the member states, including the interpretation of the legislation regarding the timing of tax deductions and the methodology of how tax deductions are calculated. Finally the tax base should be an EU consolidated taxable base, in that it will deal with cross border loss relief .
Whilst the EU has indicated that it hopes to have legislation in place by 2008, there are some significant hurdles that need to be overcome, not least that of the member states being able to agree on a fair and equitable basis of apportionment of taxable profit.
How do these cases shape the direction of EU member country legislation? ECJ decisions have shown that the ECJ is upholding the principle of the common market, with no national barriers to the free movement of goods, people, services and capital, as established under the EC treaty. EU governments have had few successes with challenges to their local legislation being incompatible with the EU treaty. There are currently a significant number of cases being referred to the ECJ, and therefore it is inevitable that there will be cases where EU member national laws have to be changed to comply with the EU Treaty.
The key point that seems to have come out of the Cadbury case is that it is acceptable within the EU to structure tax planning to take advantage of EU ‘offshore’ territories; however, there must be a real commercial substance to the entity based in that territory. There is, however, a fine line to be drawn, as the Halifax case overturned a tax structure on the basis that the structure represented an artificial structure, ie, an abuse.
EU-based companies should be reviewing current and future structures to ensure that real commercial substance exists in EU offshore tax territories. EU companies may feel more inclined to file tax returns taking an EU treaty position where this takes a more favourable stance than national laws. Clearly, this is a decision that requires considerable thought and indeed consultation with advisors.
Channel Island implications
The EU developments in terms of case law and ongoing developments such as the CCCTB do not have significant implications for standalone Channel Island companies. The EU developments do present tax planning opportunities and threats for UK parented Channel Island companies, with investments in the EU.
A simplified example of the benefit of the challenges to EU law is the case of a UK parent owned by five or fewer shareholders. UK parent owns a Channel Islands subsidiary (CI Sub), and CI Sub owns an asset with a significant unrealised gain. CI Sub could transfer the asset to a EU Subsidiary (EU Sub) of the UK parent, that was resident in an EU territory that did not tax capital gains, eg Cyprus. The asset is subsequently sold to a third party. The third party disposal would result in the gain being apportioned to the UK shareholders.
This particular circumstance, it could be argued, may be in breach of freedom of movement of capital and freedom of establishment, depending on the facts.
EU case law, albeit not in a tax case, has confirmed that the freedom of movement of capital principle extends to investment in immovable property, on the territory of member states by non-EU residents.
This clearly demonstrates that the EU has created opportunities for the Channel Islands.
The challenges to EU member states’ legislation through the ECJ could also represent a threat. Whilst it is still too early for the full impact of the Cadbury case to be considered, as the case is still to be interpreted by the UK courts in the light of the ECJ judgement, and the EU member states are still to assess their responses and any amendments to their national legislation, it is clear that the Guernsey captive insurance market is likely to be following developments in this area quite closely.
The impact of the decision could increase the relative attractiveness of EU offshore territories. In so far as the ECJ decision stands, EU offshore territories, if they are of real commercial substance, should not fall within the UK CFC legislation. Non-EU territories, such as the Channel Islands on the other hand, are likely to continue to be caught by the UK CFC legislation.
Clearly, any investment decision will need to take into account other commercial factors. Depending on the company’s risk appetite, it may also be appropriate to consider what the UK government’s likely response to the Cadbury case will be, before a final investment decision is made.
The European Court judgements are an evolving area of European law, and their impact will have significant implications for a number of years to come. The Channel Islands, being economically so closely linked to the EU, are also likely to bear some repercussions from corporate decisions as a result of these judgements – and therefore Channel Island companies can not afford to take the EU and its judicial decisions lightly.
Mark Watson, Tax Director, PricewaterhouseCoopers CI, Guernsey