The Judgment

The European Commission Decision concerned an exemption within the UK CFC rules known as the ‘group financing exemption’. Under the UK CFC rules, a CFC charge applies to non-trade finance profits of a CFC where they derive from UK activities (where the significant people and functions are based in the UK) or UK connected capital. A partial (and in some cases full) exemption applies when the non-trade finance profits arise from CFC loans made to other non-UK resident group subsidiaries.

The CJEU focused its examination on whether the General Court was correct to find that the Commission had identified the correct reference framework from which to conduct its selectivity analysis.  Selectivity exists if the measure derogates from the ordinary system of taxation (known as the reference framework) to differentiate between undertakings, which in light of the objective of the system, are in a comparable legal and factual situation. If such a derogation is found, the Member State must justify it.

The European Commission identified the UK CFC rules as the reference framework, on the basis that while an extension of the corporate tax system, the rules followed their own distinct logic and were severable from the general corporation tax rules. The UK and appellants asserted that the CFC rules, could not be viewed as severable from the general system of corporation tax in the UK, which is largely based on the principle of territoriality and in which CFC rules are a component part.

The CJEU found that when identifying the correct reference framework, it is for the Member State concerned, exercising its fiscal autonomy in the matter of direct taxation to determine the characteristics constituting the tax which defines the normal system of taxation. Therefore, the Commission is in principle required to accept the interpretation of the relevant provisions of national law given by the Member State and may only depart from that interpretation if it has reliable and consistent evidence that another interpretation should prevail based on case-law or administrative guidance of the Member State.

It concluded that the General Court was incorrect to uphold the European Commission’s identified reference framework thereby vitiating the entire selectivity analysis and the State aid Decision. It set aside the judgment of the General Court and annulled the Commission Decision. The CJEU based this conclusion in the clearest terms that the Commission should have adhered to the Member State’s interpretation of its own tax laws that the CFC rules could not be severed from the general corporation tax system, in the absence of any reliable evidence or that the Member State’s interpretation is incompatible with the wording of the legislation.

Key Take Aways

The CJEU‘s reasoning in this judgment is in line with the reasoning enunciated in the Fiat judgment (Fiat Chrysler Finance Europe and Ireland v European Commission. Joined Cases C-885/19 P and C-898/19 P) that places deference on the fiscal autonomy of Member States in the area of direct taxation, in this case to define its own system of taxation. One is left to try to reconcile this legal reasoning in the recent CJEU judgment that concluded that Ireland had granted illegal State aid to Apple (European Commission v Ireland and Apple Sales International. Case C-465/20 P). In so finding the CJEU in that case overturned the judgment of the General Court that contained a detailed analysis of the national legislation and relevant precedential case law without engaging with the principles contained in that Irish case law. It also seemed to disregard the Member State’s evidence of the provisions of Irish law.  The CJEU asserted that Irish law required that both the activities of the head office and the branch must be compared when allocating profit to the Irish branch, using OECD principles as a guide. Irish case law had in fact supported that one only looks at the branch and allocate profit based on the activities carried on in Ireland alone. Also, the OECD principles only applied to the interpretation of tax treaties and not to domestic law at the time, which was at issue.  

On balance, one must view the line of reasoning in the UK CFC judgment, which echoes that in Fiat judgment as being correct. The Apple judgment departs from those principles, and it seems to us that it is not the preferred approach.