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UK CFC Rules Still Break EU Law

May 2011 - Tax & Private Client. Legal Developments by Hassans.

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The UK must amend its legislation on the tax treatment of controlled foreign companies, as it fails to fulfil European Union (EU) Treaty obligations or adequately take into account relevant court rulings, the European Commission has said.

The formal request was made on May 19, and takes the form of a reasoned opinion, representing the second step in EU infringement proceedings.

In particular, the Commission points to the continued taxation of the UK profits of subsidiaries established in the EU or in member states of the European Economic Area (EEA). Under EU law, profits of such CFCs should not be subject to additional taxation in the country of the parent company if the subsidiaries are engaged in genuine economic activities.

The Commission stresses that the UK's legislative response to the landmark Cadbury Schweppes case in 2006 does not eliminate the discriminatory restriction of the anti-abuse CFC regime, as the rules fail to exclude from the CFC regime all subsidiaries established in EU/EEA member states which are not purely artificial and are not involved in profit-shifting transactions.

Moreover, the Commission considers that, despite having taken corrective measures, the UK is still not fulfilling the stipulations of the Treaty on the Functioning of the EU and of the EEA Agreement on the freedom of establishment and free movement of capital.

It is also noted that, in some cases, the UK's regulations may lead to the additional taxation of profits made by subsidiaries engaged in genuine economic activities in other EU member states or EEA countries.

In its most recent Budget, the government pledged to introduce new CFC rules to allow more effective competitiveness for UK based companies, but did not provide any further information on the precise nature of the changes. This reconfirmed the pledge made in November, 2010 to alter "outdated" CFC legislation.

Commenting on the proceedings, Gary Richards, Tax Partner at the City of London law firm Berwin Leighton Paisner, said that: "Today?s challenge by the European Commission to the UK's current CFC legislation could give HM Revenue and Customs (HMRC) a real headache. It is yet another move that will instil uncertainty in the UK's CFC rules, which have already caused several companies to move their headquarters out of the UK. HMRC is already in the process of reforming CFC legislation. But this new challenge, implicitly criticizing UK law for focusing too narrowly on the value of work done overseas, suggests its new proposals may need to be revised before they have even become law."

Richards added that: "On balance this challenge by the Commission is helpful for business if it means that the new rules will comply with European law. However, if HMRC choose to wait for the outcome of the challenge, rather than adjusting their current proposals, the continuing uncertainty over CFC rules will deter investors just at a time when the end seemed in sight. And UK taxpayers may face even more challenges from HMRC in other areas to 'fill the gap' if new CFC rules raise less tax from companies choosing to establish overseas bases, in lower tax jurisdictions."

The UK now has two months to provide the Commission with a satisfactory response to its request. Failure to do so may result in the UK's referral to the EU's Court of Justice.

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