Taxation of multinationals and the ECJ
Stephen Bond
Institute for Fiscal Studies
and Nuffield College, Oxford
Taxation of international companies
• How should we tax foreign-source income of
UK companies?
• i.e. income from their subsidiaries outside
the UK
• Background
• two ECJ cases decided in 2006
• review of taxation of foreign profits
announced in December 2006 PBR
• Developments in corporate tax rates in other
EU countries
Recent ECJ Cases
• Cadbury Schweppes (13 September 2006)
• concerns anti-avoidance rules for
‘Controlled Foreign Companies’
• affects taxation of profits of overseas
subsidiaries in limited circumstances
• Franked Investment Income Group Litigation
(12 December 2006)
• concerns taxation of dividend income from
overseas subsidiaries more generally
Cadbury Schweppes case
• Overseas subsidiaries of UK companies are
not normally subject to UK corporation tax
• Dividends received by UK companies from
overseas subsidiaries are normally subject to
UK corporation tax
• with credit given for foreign corporate tax
paid by the subsidiary on the underlying
profits
• Allows deferral of taxation at the UK rate,
where profits are retained in overseas
subsidiaries in countries with lower CT rates
Cadbury Schweppes case
• Controlled Foreign Companies (CFC) rules
limit this deferral benefit to parent companies
• Profits of subsidiaries that are
• located in low CT rate countries
• not considered to be normal commercial
entities
• May be apportioned back to UK and taxed as
income of the parent company
• Primarily used against ‘tax haven’ countries,
outside the EU
Cadbury Schweppes case
• UK government sought to apply CFC rules
against two subsidiaries of Cadbury
Schweppes located in Ireland
• ECJ ruled that this breached the right to
freedom of establishment in EC Treaty
• CFC rules can be applied against other EU
member states, but only when subsidiaries
are ‘wholly artificial arrangements aimed
solely at escaping national tax normally due’
Cadbury Schweppes case
• ECJ ruling weakens the conditions that
subsidiaries in other EU member states must
meet to be treated as normal commercial
entities
• December 2006 PBR announced changes to
UK CFC rules to comply with this ruling
• May allow UK (and other EU) multinational
firms to make more effective use of non-EU
tax havens
• using EU countries with weaker CFC
regimes
Franked Investment Income case
• Two common systems of cross-border double
tax relief for dividends paid by subsidiaries to
parent companies
• Credit method (UK, USA)
• Exemption method (most EU countries)
• ECJ case addressed legality of the credit
method as it operates in the UK
Franked Investment Income case
• Credit method
• a UK firm that invests in Ireland pays
corporation tax at 12.5% in Ireland on
profits of the Irish subsidiary
• dividends paid from the Irish subsidiary to
the UK parent are subject to UK
corporation tax at 30%, with credit given for
corporation tax paid by the Irish subsidiary
to the Irish government on the underlying
profits
Franked Investment Income case
• Exemption method
• a German firm that invests in Ireland pays
corporation tax at 12.5% in Ireland on
profits of the Irish subsidiary
• dividends paid from the Irish subsidiary to
the German parent are exempt from
corporate income tax in Germany
Franked Investment Income case
• As a result, a UK firm investing in Ireland may
face a higher overall corporate tax charge
than a German firm investing in Ireland
• This difference in tax treatments is not
inconsistent with EU law
• national governments may choose to handicap
their own firms operating in other member states
• both credit and exemption systems are recognised
in the EU Parent-Subsidiary Directive (July 1990)
Franked Investment Income case
• However UK corporation tax applies the
credit method to dividends received by parent
companies from overseas subsidiaries
• But exempts dividends received by parent
companies from domestic subsidiaries
• The legality of these different tax treatments
for domestic and foreign subsidiaries was
questioned in the FII case
Franked Investment Income case
• Interim Opinion of the ECJ’s Advocate
General, published 6 April 2006, suggested
this aspect of the operation of the credit
method in the UK may be contrary to EU law
• ECJ ruling on 12 December 2006 indicates
that different procedures can be used,
provided they result in comparable tax
charges
• Case referred back to UK High Court to
decide whether or not this applies
Taxation of foreign profits
• Developments in this case during 2006
required UK government to consider how it
would respond if some elements of the
existing credit system were ruled to be in
breach of EU law
• December 2006 PBR announced that a
consultation process to consider possible
reforms to the taxation of foreign profits will
be conducted during 2007
Taxation of foreign profits
• This review is important, as international
companies account for a growing share of
economic activity
• Outcome could influence whether the UK
remains an attractive location of residence for
major multinational companies
• Scope is not yet clear, but should be wideranging and consider the case for moving to
an exemption system
Taxation of foreign profits
• How serious a handicap is the credit system for
UK companies that operate internationally?
• Difficult to say
• Many international firms operate
successfully from the UK
Taxation of foreign profits
• What would be the revenue cost of exempting
foreign-source dividends?
• Difficult to say
• Large firms can avoid UK tax on foreignsource dividends by
• retaining profits in overseas subsidiaries
• routing dividend payments through subsidiaries
located in countries with higher CT rates (in
which case the credit available wipes out the
UK corporation tax liability)
Taxation of foreign profits
• How could any revenue cost be recouped?
• Tempting to restrict interest deductibility: why
should interest payments on debt used to fund
overseas investment be deductible against UK
corporation tax, if profits of overseas
subsidiaries are exempt from UK corporation
tax?
• But impossible to determine which borrowing
funds which investment: ‘interest allocation
rules’ tend to be both complex and arbitrary
Taxation of foreign profits
• Major attraction of the exemption method
would be potential for simplicity
• But hard to be confident that a package of an
exemption system with interest allocation
rules would be simpler than the present credit
system
Corporate tax rates
• Concerns over the ‘competitiveness’ of UK
corporation tax also stem from recent
developments in corporate tax rates
• Particularly in other EU countries
Corporate tax rates
• 1997
• UK CT rate at 33%
• 4th lowest of the 15 EU countries
• 1999
• UK CT rate at 30%
• still 4th lowest of the 15 EU countries
• Jan 2007
• UK CT rate still at 30%
• now 6th highest of the EU-15
• all new member states have lower CT rates
except Malta
Corporate tax rates
• Unlikely that the UK corporate tax regime in
2007 appears as attractive to firms
contemplating investments in Europe as it
would have done, compared to other EU
locations, a decade earlier
• Hence growing concerns about the impact of
UK corporation tax on business investment
and location choices
Summary
• Announced review of the taxation of foreign
profits is important and should be wideranging
• Corporate tax rates have fallen faster in other
EU countries than in the UK over the last
decade, and particularly since 1999