Territoriality and the Tax Treatment of Intra-group Transactions

A special tax rule can constitute the reference or normal system of taxation if it is “severable” from other tax rules and has its own legal logic.

Introduction

The application of State aid rules to the tax treatment of transactions between companies that belong to the same multinational group is contentious. During the past three years or so, the Commission won three cases (Fiat [September 2019], Engie [May 2021], UK CFC [June 2022]), but lost four (Starbucks [September 2019], Apple [July 2020], Amazon [May 2021], Gibraltar [April 2022]). The Commission also won two other cases on procedural grounds (Belgium [September 2021], Nike [July 2021]).

The Commission’s latest success was on 8 June 2022 in cases T‑363/19 and T‑456/19, UK & ITV v European Commission.[1] The UK and ITV sought the annulment of Commission Decision 2019/1352 concerning State aid granted by the UK through the group financing exemption for “controlled foreign companies” [CFC].

ITV is a television company that also owns companies established in the Netherlands. The profits from the interest on certain of the loans made by CFCs belonging to ITV were exempted from tax.

In the UK, companies are taxed on their profits arising from their UK operations in accordance with the principle of territoriality. This means that the profits of foreign companies which are redistributed in the UK are not taxed. Similarly, profits attributable to foreign permanent establishments are not subject to corporation tax in the UK.

The rules on CFCs determine whether the profits of a CFC can be regarded as having been artificially diverted from the UK whereas they should have been taxed in the UK. If they are deemed to be artificially diverted they are taxed in the UK by means of the so-called CFC charge. For example, CFC’s non-trading finance profits are taxed in the UK when they are deemed to arise from activities that are actually carried out in the UK, even though formally they attributed to a foreign company. The main criterion which is used to determine where the main activity is carried out is the location of the “significant people functions”.

Commission Decision 2019/1352 found that the group financing exemption scheme, constituted State aid in so far as it applied to non-trading finance profits from “qualifying loans”. This was because the exemptions benefited companies established in the UK that were part of multinational groups by relieving them from tax on 75% of the profits on those loans.

How to determine the existence of a selective advantage

The General Court, first, examined the pleas alleging that the CFC exemption did not confer any advantage.

It began its analysis by noting that “(59) both the examination of the criterion of advantage and that of selectivity involve, at the outset, determining the normal taxation rules forming the relevant reference framework for that examination.”

“(60) In the case of tax measures, the very existence of an advantage may be established only when compared with ‘normal’ taxation […] Such a measure confers an economic advantage on its recipient if it mitigates the burdens normally included in the budget of an undertaking and which, accordingly, without being subsidies in the strict meaning of the word, are similar in character and have the same effect […] Thus, it is precisely the ‘normal’ taxation which is established by the reference framework.”

Then the Court reiterated the well-established principle that in tax matters selectivity is determined in three stages:

First, identification of the ordinary or ‘normal’ tax system which constitutes the reference framework.

Second, demonstration that the tax measure at issue is a derogation from that reference framework because it differentiates between operators who, in the light of the objective pursued by that reference framework, are in a comparable legal and factual situation.

Third, justification of the a priori differentiation on the basis of the nature or general structure of the tax framework.

The definition of the reference system

The applicants alleged that the Commission made an error in considering that the reference system consisted solely of the rules applicable to CFCs instead of the overall UK corporation tax system.

The General Court observed that “(65) outside the spheres in which EU tax law has been harmonised, it is the Member State concerned which defines, by exercising its exclusive competence in the matter of direct taxation, the characteristics constituting the tax, the determination of the reference system or the ‘normal’ tax regime, from which it is necessary to analyse the condition relating to selectivity, must take account of those characteristics”.

“(66) Moreover, as for a tax measure of general application, it is necessary to identify the ordinary tax system or the reference system applicable in the Member State concerned, since it constitutes the starting point for the comparative examination to be carried out in the context of the assessment of the selectivity of an aid scheme”.

“(67) Furthermore, […], where there is a general tax rule applicable to all undertakings subject to corporation tax, a rule which constitutes an exception to the general rule cannot be used as a relevant reference system for the purposes of analysing selectivity”.

In other words, in identifying the reference system one has to go to the highest or widest applicable level or rule.

“(68) In addition, […] the selectivity of a tax measure cannot be assessed on the basis of a reference framework consisting of some provisions of the domestic law of the Member State concerned that have been artificially taken from a broader legislative framework. 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”.

In other words, one has to go to the highest or widest applicable level or rule but not if the rule in question can stand on its own because it has its own logic or purpose and therefore is severable from other rules.

The General Court also recalled the well-established principle that “(70) the regulatory technique used cannot be decisive for the purposes of the determination of the reference framework”.

Then the General Court referred to the definition of the reference system in the Commission Notice on the Notion of State Aid. “(72) It is stated in particular in paragraph 133 of the 2016 Notice that the reference system is composed of a coherent set of rules which apply generally – on the basis of objective criteria – to all undertakings within its scope as defined by its objective. Typically, those rules define not only the scope of the system, but also the conditions under which the system applies, the rights and obligations of undertakings subject to it and the technicalities of the functioning of the system.” “(73) In addition, paragraph 134 of the 2016 Notice states that, in the case of taxes or levies, the reference system is based on such elements as the tax base, the taxable persons, the taxable event and the tax rates. In that regard, it is apparent from the case-law that, in particular, the tax rate, as well as the determination of the tax base and the taxable event are characteristics constituting the tax that define the reference system or the ‘normal’ tax regime, from which it is necessary to analyse the condition relating to selectivity”.

In the contested decision, the Commission considered that the reference system consisted of the rules applicable to CFCs.

In other words, the reference system, in the Commission’s view, was not the highest or widest possible, which would have been the normal system of corporate taxation because the CFC rules were severable from the other tax rules.

The General Court summarised the issue at hand as follows. “(77) The rules applicable to CFCs provide for the taxation in the United Kingdom of profits made by the CFC which are, in reality, attributable to their related company, taxable in the United Kingdom, in so far as that company is responsible for the activities or assets which generated those profits or in so far as the profits of the CFC are part of arrangements for the diversion of funds which would otherwise have been taxable in the United Kingdom.”

But since the tax rules applicable to CFCs form part of the general UK corporation tax system, the Court deemed it “(79) necessary to examine to what extent those rules are severable from that general tax system, in that they appear to be a consistent body of rules with its own legal logic, […], in particular as regards factors such as the tax base, the taxable persons, the taxable event and the tax rates.”

“(80) First, as regards the underlying logic of the rules applicable to CFCs, it should be recalled, […], that the general corporation tax system of [the UK] is 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.”

“(81) 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.”

“(82) Thus, the rules applicable to CFCs are based on a logic distinct from that of the general tax system in the United Kingdom. […] it is severable from it.”

“(83) Those rules do not constitute an exception to the general tax system, since they may rather be regarded as an extension thereof. The rules applicable to CFCs are intended to tax profits which have been artificially diverted from the United Kingdom and, as a result, have artificially increased the profits of the CFC, which will then distribute dividends which are not taxable in the United Kingdom. Thus, the logic of the rules applicable to CFCs is linked to the diversion of profits to CFCs, so that, in practice, they are accrued outside the United Kingdom. It is therefore distinct from that underlying the general United Kingdom corporation tax system, which is based on profits made in the United Kingdom.”

“(84) Second, it must be ascertained whether, in the light of the characteristics constituting the tax that define the ‘normal’ tax regime, the rules applicable to CFCs may be regarded as constituting a complete body of rules, distinct from the general United Kingdom corporation tax system.”

Then the General Court, in paragraphs 85-88, examined in turn the tax base, the taxable persons, the taxable events, and the tax rate, and concluded that the CFC rules were separate from the normal system of corporate taxation so that they could be regarded as “(89) an autonomous body of specific rules governing the taxation in the United Kingdom of profits made by CFCs.”

“(91) It must be found that the Commission did not make an error of assessment in considering that the rules applicable to CFCs constituted a separate body of tax rules within the general United Kingdom corporation tax system and adopting those rules as reference system for the purposes of its analysis.”

The existence of an advantage

The applicants claimed that no advantage had been granted by the exemption of that applied to certain CFC profits.

The General Court, first, recalled that “(99) in order to determine whether there is a tax advantage, the position of the recipient as a result of the application of the measure at issue must be compared with his position in the absence of the measure at issue and under the normal rules of taxation”.

The General Court pointed out that the exemption at issue allowed a company established in the UK which was subject to a CFC charge to request that the CFC charge be set at 25% of the CFCs non-trading finance profits arising from qualifying loans.

The General Court concluded that “(104) the fact of providing for an exemption for 75%, or even 100%, of those CFCs profits, which would have been regarded as having been artificially diverted from the United Kingdom and, therefore, which should have been taxed there on that basis, reduces the charges which are normally included in the budget of the company taxable in the United Kingdom as a result of those profits.”

Purpose of the CFC rules

But, the applicants claimed that the Commission was wrong to take the view that the objective of the rules applicable to CFCs was limited to the taxation of artificially diverted profits.

The General Court noted that “(111) for the purposes of the comparability analysis inherent to the examination of selectivity in the context of the second step of the analysis […], the determination of the objective of the tax system concerned is of decisive importance, since it is in the light of that objective that the legal and factual situation of the economic operators concerned must be compared.”

“(112) The condition relating to the selectivity of the advantage, […], requires a determination as to whether, under a particular legal regime, the national measure at issue is such as to favour ‘certain undertakings or the production of certain goods’ over other undertakings which, in the light of the objective pursued by that regime, are in a comparable factual and legal situation and which accordingly suffer different treatment that can, in essence, be classified as discriminatory”.

The Commission had taken the view that the objective of the CFC rules was to protect the UK corporation tax base.

The General Court noted that “(114) in the present case, the parties disagree, essentially, on whether the objective of the rules applicable to CFCs is to protect the tax base of United Kingdom corporation tax, as claimed by the United Kingdom and ITV, or the taxation of artificially diverted profits from the United Kingdom, as argued by the Commission.”

Then it observed that “(115) the two positions summarised in paragraph 114 above do not in actual fact constitute opposing positions, since the protection of the tax base of United Kingdom corporation tax is a broad objective, within which falls the more specific objective of taxing profits artificially diverted from the United Kingdom.”

For this reason the Court agreed with the Commission.

Selectivity arising from a derogation from the reference system

Then in examining whether the CFC exemption was selective, the General Court reiterated that “(124) in the context of the second stage of the analysis of the selectivity of tax measures, […], the Commission must demonstrate that the tax measure at issue derogates from the reference system identified in the first stage, in so far as it introduces a differentiation between operators who, in the light of the objective assigned to the relevant tax system, are in a comparable factual and legal situation.”

The Commission had established the existence of a selective advantage by comparing the situation of companies that benefited from the exemption with that of the companies to which such an exemption did not apply. In the former case the profits were from qualifying loans, while in the latter case the profits were from non-qualifying loans.

In order to determine the correctness of the Commission’s comparison, the General Court ruled that it was “(126) necessary to examine, first of all, the conditions required for the grant of the exemptions at issue, in particular those relating to whether loans are qualifying or non-qualifying loans, so as to concentrate next on the inherent characteristics of non-qualifying loans, in order to examine, finally, whether the Commission was correct in finding that the contested measures had introduced differentiations between operators in a comparable situation.”

Conditions for the grant of the exemption in question

The General Court considered that, first, “(131) the exemptions at issue affect non-trading finance profits […] which are considered to be taxable in the United Kingdom, and therefore liable to be subject to a CFC charge”. Second, “(137) in order to benefit from the exemptions at issue, the non-trading finance profits in question must have arisen from qualifying loans. […] qualifying loans are loans granted by a CFC to other companies that are not resident in the United Kingdom and controlled by the same company or companies as that or those that control the CFC.”

“(143) In the light of the foregoing considerations, it must be observed that, […], those exemptions are granted irrespective of whether significant people functions have been carried out in the United Kingdom as regards the loans from which the non-trading finance profits in question arise.”

The General Court pointed out that “(144) the condition common to the […] exemptions at issue is that of whether the loans are qualifying or non-qualifying loans. Accordingly, non-trading finance profits arising from non-qualifying loans are excluded from those exemptions.” In the UK tax system, loans granted to a company established in the UK are excluded from the definition of qualifying loans. Also loans granted by CFCs to companies in the group resident in the UK are regarded as non-qualifying loans. Since qualifying loans must be granted to qualifying companies, loans to companies outside the CFC group are excluded from the definition of qualifying loans.

The comparability of the operators concerned, in the light of the objective of that system

The General Court pointed out that “(161) the reference system in relation to which the exemptions at issue must be analysed consists of the rules applicable to CFCs, which seek to protect the tax base of the United Kingdom corporation tax, by taxing the profits arising from United Kingdom activities and assets which are artificially diverted from the United Kingdom to CFCs.” “(162) Within the rules applicable to CFCs, the non-trading finance profits made by the latter, relating to significant people functions carried out in the United Kingdom, were regarded as profits artificially diverted from the United Kingdom and, therefore, taxable”. “(164) In other words, the United Kingdom legislature considered that CFCs profits, in so far as they are generated by significant people functions carried out in the United Kingdom, must be taxed therein. For that reason, the non-trading finance profits generated in the context of both non-qualifying loans and qualifying loans may be subject to a CFC charge”.

“(165) It must be held that, by applying the exemptions concerned, it cannot be ruled out that situations in which significant people functions were carried out in the United Kingdom, and therefore regarded as constituting an artificial diversion of profits, may be partially or totally exempt from taxation in the United Kingdom.”

“(166) In those circumstances, the fact of exempting only CFCs non-trading finance profits arising from qualifying loans could lead to different treatment as opposed to CFCs non-trading finance profits in the context of non-qualifying loans which, since they do not benefit from the exemptions concerned, would be taxed under the rules applicable to CFCs, in the event that those two situations were comparable, in the light of the objective of the rules applicable to CFCs.”

“(167) Thus, it is necessary to examine whether companies taxable in the United Kingdom which may benefit from the exemptions at issue in respect of their CFCs non-trading finance profits arising from qualifying loans are in the same situation as companies whose CFCs have made non-trading finance profits arising from non-qualifying loans, in the light of the objective of the reference system, namely the protection of the tax base of United Kingdom corporation tax through the taxation of artificially diverted profits.”

“(181) It follows from the foregoing that the exemptions at issue, in so far as they exempt only CFCs non-trading finance profits arising from qualifying loans, to the exclusion of those arising from non-qualifying loans, lead to a difference in treatment of the two situations even though they are comparable, in the light of the objective pursued by those rules, consisting in protecting the tax base of the corporation tax in the United Kingdom through the taxation of artificially diverted profits.”

Conclusion on the existence of an advantage and derogation from the reference system

The General Court concluded that “(182) in the light of the considerations set out in paragraphs 108, 120, 143, 160 and 181 above, it must be held that the Commission did not commit any errors of assessment when it concluded that there was an advantage in the present case and that it was a priori selective, since the exemptions at issue derogated from the United Kingdom rules applicable to CFCs, in that they introduced a difference in treatment between taxable companies in a comparable situation, in the light of the objective of those rules.”

Alleged errors of assessment concerning the existence of justifications for the exemptions

The applicants claimed that the exemptions were justified by reasons of administrative practicability, given the complexity of determining the location where significant people functions were carried out, and compliance with the freedom of establishment.

Administrative practicability

“(186) It should be recalled that […] a measure which creates an exception to the application of the general tax system may be justified by the nature and overall structure of that tax system if the Member State concerned can show that that measure results directly from the basic or guiding principles of its tax system, in particular the mechanisms inherent in the tax system itself which are necessary for the achievement of such objectives”.

“(187) It has been accepted that objectives inherent in the general tax system concerned could justify an a priori selective tax regime […], in particular the objectives linked to the proper functioning of the tax system in question”.

“(193) The United Kingdom tax authorities themselves acknowledged that for larger, medium- to long-term loans funded by equity, it was generally expected that, in most cases, the management of those loans would be part of a group’s financing function and that experience had shown that this type of loan was planned and managed at the level of the group’s central structures. Such a consideration is indicative of the fact that, for a large part of intra-group loans, the question of the identification and location of the significant people functions does not even arise, since those functions can be presumed to have been carried out at central level in the United Kingdom.”

“(194) As regards more specifically the partial exemption of 75% of the non-trading finance profits, as the Commission rightly states, no evidence shows the extent to which the 75% exemption threshold was necessary or appropriate in cases where a CFC charge would have been payable on the basis of the general criterion of significant people functions carried out in the United Kingdom.”

The General Court rejected the plea.

Compliance with the freedom of establishment

“(199) It should be borne in mind that the United Kingdom tax system is based on the principle of territoriality and that, according to that principle, the profits made by CFCs are not taxed in that State. However, where those profits are in fact profits attributable to an entity resident in the United Kingdom which was responsible for the funds or significant people functions carried out in connection with the loans which generated those profits, they are regarded as having been artificially diverted and, therefore, as being taxable in the United Kingdom, through a CFC charge. Thus described, that system cannot be regarded as constituting an obstacle to freedom of establishment.”

Effect on trade between Member States

The UK claimed that the Commission failed to demonstrate that multinational groups were encouraged to relocate the group’s finance functions as a result of the exemptions at issue and therefore that trade between Member States was affected by those exemptions.

The General Court recalled that “(205) the Commission is not required to establish that a State measure has a real effect on trade between Member States and that competition is actually being distorted. The Commission is required only to establish that that measure is liable to have such effects”.

“(206) Thus, […], when aid granted by a Member State strengthens the position of certain undertakings compared with other undertakings competing in trade between Member States, such trade must be regarded as having been affected by that aid”.

“(207) The Commission correctly concluded that the exemptions at issue constituted a selective advantage benefiting companies which had relied on them. In those circumstances, it is also necessary to endorse the Commission’s assessment that that advantage is liable to have an effect on trade between Member States because it strengthens the position of the recipient companies. Furthermore, that selective advantage is liable to affect decisions to relocate capital and activities within multinational groups established within the European Union, and more particularly treasury functions.”

“(208) Moreover, contrary to what the United Kingdom claims, the Commission is not required to prove actual movements by international groups, or to compare the different tax systems within the European Union, provided that it is able to demonstrate the existence of an advantage capable of strengthening the competitive position of its beneficiaries”.

Breach of the principle of non-discrimination

ITV complained that the Commission breached the principle of non-discrimination in that it applied more favourable treatment from a State aid perspective to other intra-group finance transactions, in particular in two previous decisions, than the treatment which emerges from its position in the present case.

The General Court rejected this argument on the following grounds.

“(212) The principle of equal treatment and non-discrimination requires that comparable situations must not be treated differently and that different situations must not be treated in the same way unless such treatment is objectively justified”.

“(213) It should be observed that it is only in the context of Article 107(3)(c) TFEU that the validity of a Commission decision finding that a State measure constitutes State aid must be examined, not by reference to an earlier practice of the Commission in taking decisions. The concept of State aid meets an objective situation which is assessed on the date on which the Commission adopts its decision. Thus, the reasons why the Commission had made a different assessment of the situation in a previous decision cannot therefore have any effect on the assessment of the legality of the contested decision”.

“(214) Thus, the fact that the Commission recognised, in other decisions, the existence of differences between intra-group loans and loans between third-party companies does not in itself mean that, in the present case, the existence of a selective advantage cannot be established.”

“(215) Such a conclusion must be based on a detailed analysis of the taxation regarded as normal in the State concerned and on the question whether, as a result of the State measure in question, there was a derogation from that taxation which introduced differences in treatment between economic operators which, in the light of the objective assigned to the relevant tax system, were in a comparable factual and legal situation.”

“(216) Moreover, as the Commission rightly submits, the comparability between operators must be made precisely in the light of the objective of the system at issue. Therefore, in view, in particular, of the fact that the objective of the systems at issue in each of the Commission’s decisions was different, no conclusion can be drawn from any differences in the Commission’s assessment in the context of the decisions relied on by ITV and in the present case.”

Since the General Court rejected all pleas, it dismissed the action for annulment in its entirety.

[1] The full text of the judgment can be accessed at:

CURIA – Documents (europa.eu)

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Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He is professor at the University of Maastricht and the University of Nicosia. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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