Introduction
Taxes are burdens on undertakings. They cannot be State aid. However, tax exemptions or reductions can be State aid if they cannot be objectively justified. When a tax measure is in the form of a reduction or exemption, it is relatively easy to establish its selectivity in the meaning of Article 107(1) TFEU. However, when a tax is levied on some undertakings but not on others, then it becomes more difficult to determine whether the non-taxation is an exemption which is selective or simply an objectively justified definition of the scope of the tax. It all depends on proper identification of the reference system.
On 19 September, the Court of Justice of the EU [CJEU], in case C‑555/22 P, UK v Commission, had to rule on whether the reference tax system was correctly defined and on whether deviations from that system could be justified.[1]
The case concerned an appeal by the UK, supported by several other parties, against the judgment of the General Court in case T-363/19, UK v Commission by which the General Court dismissed their actions seeking annulment of Commission decision 2019/1352. In that decision, the Commission found that the UK had granted incompatible State aid to controlled foreign companies [CFCs].
The UK’s corporate tax system is based on the principle of territoriality. That is, companies pay tax only on profit they generate in the UK. Consequently, neither profits from foreign operations, nor profits attributed to foreign companies are taxed in the UK. For this reason, the UK also has special tax rules on foreign companies which are controlled by resident UK companies. The purpose of these rules is to prevent UK companies from using CFCs to carry out activities in the UK, attribute income and profit to them and in this way avoid paying tax in the UK. These rules determine when an activity that is carried out by a CFC should in reality be attributed to the controlling UK company. If profits are deemed to be diverted to a CFC, they are subject to the so-called “CFC charge”.
The profits which are relatively easier to divert are those that are generated by services or intangible activities such as the provision of office and administration services, finance advice, treasury management, etc.
In this case, the General Court agreed with the Commission’s assessment that the measure in question was selective because it differentiated between CFCs in the context of the overall framework of the CFC rules which were considered to make up the reference tax system [see below for a more detailed explanation]. In essence, some CFCs were subject to the CFC charge while some others were not. The non-application of the CFC charge was deemed to be the selective tax measure at issue.
However, the CJEU ruled that both the General Court and the Commission were wrong. The reference system was the UK general corporate tax system. Even though the tax on companies is levied on profits generated in the UK, the purpose of the CFC charge is to prevent diversion of UK profits to CFCs. The CFCs exempted from the charge are those that generate their profits outside the UK or are less likely to receive diverted profits from UK-based activities. Hence, the CFC charge is inseparable from the UK general corporation tax and cannot be a distinct reference system.
The reference system: Principles
The CJEU, first, recalled the well-established principle that although Member States are free to determine their tax systems, they must, nevertheless, comply with EU State aid rules. Then, in order to determine whether a tax measure confers a selective advantage, it is necessary to determine the reference system and whether the measure in question is a derogation or exception from that system or the normal tax base or rate.
Next, the CJEU stressed that “(94) the determination of the reference framework is of particular importance in the case of tax measures, since the existence of an economic advantage for the purposes of Article 107(1) TFEU may be established only when compared with ‘normal’ taxation. Thus, determination of the set of undertakings which are in a comparable factual and legal situation depends on the prior definition of the legal regime in the light of whose objective it is necessary, where applicable, to examine whether the factual and legal situation of the undertakings favoured by the measure in question is comparable with that of those which are not”.
“(95) The determination of the reference framework, […], must follow from an objective examination of the content, the structure and the specific effects of the applicable rules under the national law of that State. In that regard, the selectivity of a tax measure cannot be assessed on the basis of a reference framework consisting of some provisions of the national law of the Member State concerned that have been artificially taken from a broader legislative framework. Consequently, where the tax measure in question is inseparable from the general tax system of the Member State concerned, reference must be made to that system. On the other hand, where it appears that such a measure is clearly severable from that general system, it cannot be ruled out that the reference framework to be taken into account may be more limited than that general system, or even that it may equate to the measure itself, where the latter appears as a rule having its own legal logic and it is not possible to identify a consistent body of rules external to that measure”.
Indeed, because taxes are levied for many different purposes [e.g. raise revenue for the government, penalise environmentally harmful activities, discourage consumption of alcohol, etc.], the reference system can be very narrow and in some cases it can be the tax itself.
The CJEU also warned that “(96) it is the Member State concerned which determines, by exercising its own competence in the matter of direct taxation and with due regard for its fiscal autonomy, the characteristics constituting the tax, which define, in principle, the reference framework or the ‘normal’ tax regime, from which it is necessary to analyse the condition relating to selectivity. This includes the determination of the tax base, the taxable event and any exemptions to which the tax is subject”.
This is important because, “(97) when determining the reference framework for the purpose of applying Article 107(1) TFEU to tax measures, the Commission is in principle required to accept the interpretation of the relevant provisions of national law given by the Member State concerned in the exchange of arguments referred to in paragraph 95 of this judgment, provided that that interpretation is compatible with the wording of those provisions”.
The CJEU added that “(98) the Commission may depart from that interpretation only if it is able to establish, […], that another interpretation prevails in the case-law or the administrative practice of that Member State”.
A case in point is the recent judgment in case T‑12/15, Banco Santander v Commission, whereby the General Court faulted the Commission for failing to understand correctly the interpretation of the Spanish tax provisions on amortisation of goodwill. Even the practice of the tax authorities deviated from the interpretation in the Spanish case law. This case was reviewed here on 7 November 2023. It can be accessed at:
The reference system for the CFCs
On the basis of the above principles, the CJEU began its assessment of whether the General Court and the Commission were correct to find in the present case that the reference framework was limited to the rules applicable to CFCs.
“(101) To that end, it should be recalled that, […], as regards the underlying logic of the rules applicable to CFCs, the General Court noted that the GCTS [the General Corporation Tax System] was based on the principle of territoriality, ‘under which only profits made in the United Kingdom are taxed, namely profits made by companies established in that State or profits made by foreign companies arising from their activities in the United Kingdom through a permanent establishment in that State’.
“(102) The General Court pointed out that, under the rules applicable to CFCs, ‘certain profits made by CFCs which, according to the principle of territoriality, are not normally taxed in the United Kingdom may nevertheless be taxed when they are considered to have been artificially diverted from the United Kingdom’. It concluded from this, […], that the rules applicable to CFCs were based ‘on a logic distinct from that of the [GCTS]’, whilst specifying that ‘that logic [was] admittedly supplementary or […] a corollary to the [GCTS] based on the principle of territoriality, however it [was] severable from it’.”
“(103) The General Court added, first, that the rules applicable to CFCs ‘[did] not constitute an exception to the [GCTS], since they [might] rather be regarded as an extension thereof’, next, that those rules were ‘intended to tax profits which [had] been artificially diverted from the United Kingdom and, as a result, [had] artificially increased the profits of the CFC, which [would] then distribute dividends which [were] not taxable in the United Kingdom’ and, lastly, that ‘the logic of [those] rules [was] linked to the diversion of profits to CFCs, so that, in practice, they are accrued outside the United Kingdom’. It concluded that that logic was ‘distinct from that underlying the [GCTS], which [was] based on profits made in the United Kingdom’.”
Next, the CJEU observed that “(104) an element classified as ‘a corollary to’, ‘supplementary to’ or ‘an extension of’ a main element can hardly be regarded as being clearly severable from that latter element or as following its own legal logic, within the meaning of the case-law cited in paragraph 95 of the present judgment.”
“(105) Owing to the close relationship which normally exists between those two elements, the fact of creating a separation between them amounts, in principle, to artificially removing certain provisions of the national law of the Member State concerned from the broader legislative framework of which they form part, in breach of the principles recalled in paragraph 95 of the present judgment.”
“(106) Thus, unless it is supplemented by other rules, the GCTS does not make it possible for the profits made by CFCs of United Kingdom companies to be taxed, despite the fact, highlighted by the General Court, that those companies receive from their CFCs dividends, which are not taxable in the United Kingdom, by virtue of the provisions of the GCTS.”
Then the CJEU considered whether the CFC rules were an exception to the GCTS. “(107) According to the appellants, in essence, the rules applicable to CFCs are an exception to the principle of territoriality which largely characterises the GCTS and are intended to supplement it, with a view to taxing, by means of the CFC charge to which United Kingdom companies which control CFCs are subject, the profits of those CFCs in the same way as they would have been if they had been made by those United Kingdom companies, where there is a sufficiently high risk that those profits result from arrangements which give rise to artificial diversion of profits or erosion of the tax base of United Kingdom corporation tax. On the other hand, the exemptions at issue allow, in the absence of a sufficiently high risk, the profits concerned not to be subject to any CFC charge, in the same way as they would not have been taxed under the GCTS, or even though that charge applies to only part of the profits, in accordance with a flat-rate estimate of the effects of those arrangements on the tax base.”
“(108) If that interpretation of the rules applicable to CFCs and their relationship with the GCTS were to be upheld, those rules would have to be regarded as following the same logic as the GCTS. By virtue of that interpretation, first, they introduce an exception to the principle of territoriality which largely characterises the GCTS in order to prevent profits which, in the absence of diversion or erosion of the tax base, would have been taxed under that system from escaping the United Kingdom taxation authorities. Second, through the exemptions at issue, they form part of the largely territorial nature of the GCTS, in the sense that the CFC charge is not, or is not fully, applied where the risk of artificial diversion of profits or the erosion of the tax base of United Kingdom corporation tax is not sufficiently high. In other words, according to the appellants’ interpretation, the GCTS and the rules applicable to CFCs are inseparable within the meaning of the case-law referred to in paragraph 95 of the present judgment.”
Therefore, it was necessary for the CJEU to decide which interpretation of national law could prevail: that of the Commission, as confirmed the General Court, or that of the appellants.
After examining the relevant UK tax provisions, the CJEU concluded that “(114) nothing in those [provisions], precludes the interpretation of the rules applicable to CFCs advocated by the United Kingdom”.
The CJEU also noted that CFCs were exempted from the CFC charge only when there was little risk for diversion of profits away from the UK. Consequently, CFC profits could be “(122) exempted, in whole or in part, from the CFC charge, […], on the ground that, according to the assessment made by the United Kingdom legislature, the fact that those conditions are satisfied makes it possible to rule out the existence of a sufficiently high risk that those profits result from arrangements which give rise to the artificial diversion of profits or the erosion of the tax base of United Kingdom corporation tax.”
“(127) It follows that, […], the rules applicable to CFCs, taken as a whole and, in particular, as regards non-trading finance profits, […], supplement the GCTS, and follow the same logic which is largely based on the principle of territoriality. The CFC charge is not applied, or is applied only at a reduced level, to CFCs’ non-trading finance profits, such as those arising from qualifying loans, which do not have a sufficient territorial connection with the United Kingdom and which therefore do not constitute artificially diverted profits or an erosion of the tax base of United Kingdom corporation tax.”
Then, the CJEU identified the erroneous parts of the judgment of the General Court. “(129) First, as regards the tax base, […], the General Court wrongly distinguishes between profits made in that State and profits artificially diverted from it, in order to consider them to be two different tax bases. In both cases, the tax base corresponds to the profits made.”
“(130) Second, as regards taxable persons, it should be noted that the persons liable to pay the CFC charge are parent companies established in the United Kingdom, namely companies which are also subject to corporation tax in the United Kingdom. It is true that that represents a subset of companies established in the United Kingdom, since all those companies do not necessarily control CFCs whose profits trigger a CFC charge. The fact remains however that, within that subset, the same companies are subject to both corporation tax and to the CFC charge. The General Court was therefore wrong to consider that there was a relevant distinction between those liable to pay the CFC charge and those liable to pay the tax resulting from the GCTS.”
“(131) Third, as regards the taxable event, the General Court found that a CFC charge is applied where CFCs make profits outside the United Kingdom arising from purely artificial arrangements or diversions of resources or profits which should have been taxed in the United Kingdom. It concluded that the taxable event for that charge did not correspond to the making of profits in the United Kingdom taxable under the GCTS. In so doing, the General Court misinterpreted the concept of the taxable event, since, in both cases, the event justifying the imposition of tax on a person is the making of profits by that person.”
“(132) Fourth, as regards the tax rate of the CFC charge, that rate is the same as for the tax laid down in the GCTS, as the General Court accepted. It is true that the General Court added that, as regards the CFC charge, there is a specific calculation mechanism in which account may be taken of the average of several tax rates applicable to the profits of the company taxable in the United Kingdom. However, […], the possibility that the tax rate corresponds to the average of several rates exists both for the CFC charge and for corporation tax established in the United Kingdom.”
“(133) Fifth, while it is common ground that [the relevant rule] contains specific provisions concerning the calculation of the CFC charge, those rules are, in essence, identical to those of the GCTS in many respects”.
“(134) Sixth, […] the General Court was wrong to find that the existence of a mechanism for the avoidance of double taxation was a specific feature of the rules applicable to CFCs.
The CJEU concluded that “(135) it follows from all those considerations that the rules applicable to CFCs form an integral part of the GCTS, which they supplement, following the same logic as the latter, according to which profits with a sufficient territorial link with the United Kingdom are subject to tax. Therefore, […], the General Court erred in law when it confirmed that, […], the reference framework for the purposes of examining the selectivity of the exemptions at issue in the light of Article 107(1) TFEU consisted solely of the rules applicable to CFCs”.
Given that the correct determination of the reference system is indispensable in establishing the existence of a selective advantage, the CJEU annulled in its entirety the judgment of the General Court and proceeded to render final judgment itself. Since the General Court had endorsed the Commission’s assessment of the reference system, the CJEU also annulled Commission decision 2019/1352.
The full text of the judgment can be accessed at: