Your argument isn’t with Vodafone, it’s with the European Court of Justice

On Saturday 30 October 2010, several Vodafone stores were forced to close by protesters demanding the company settle a £6 billion unpaid tax bill.  Vodafone disputes that this tax is owed, with the BBC reporting that “… a Vodafone spokesman denied the tax bill reports, adding: “We pay our taxes in the UK and all of the other countries in which we operate.”" To add to the confusion, an unnamed source at HMRC is reported to have referred to the figure of £6 billion as “an urban myth.”  Is it possible to get any closer to the heart of the issue without access to the company’s and HMRC’s records?

The £6 billion unpaid tax was a back of envelope figure published by Private Eye. To arrive at this figure, you need to make the following assumptions:

• The Vodafone Luxembourg subsidiary which has been earning interest on an intragroup balance since 2000 meets the UK tax definition of a controlled foreign company (CFC);
• That UK CFC rules can be applied in this case without violating EU law (the right to freedom of establishment); and
• The total pre-tax profit in this company should therefore be subject to tax at the UK large company rate.

This post sets out to consider the first and second of those assumptions.  However, the third assumption, it should be noted, is a large one and would need to be explored before any credible tax liability figure could be established.

What is a CFC?

The FT Lexicon gives us the following explanation: “The UK Controlled Foreign Company (CFC) tax regime applies, broadly, to companies controlled in the UK but resident in an overseas territory in which they are subject to a lower level of tax (less than 75 percent of the tax which would have been charged had the company been UK resident). Exemptions apply, but where a company is deemed a CFC the relevant portion of its profits is brought into UK tax in the computations of its UK resident corporate shareholders.”

The FT Lexicon goes on to summarise the case of Cadbury Schweppes plc and Cadbury Schweppes Overseas Limited v Commissioners of Inland Revenue, which was referred to the European Court of Justice (ECJ) by the Special Commissioners. In 2006, the ECJ found that the UK CFC rules, as they were being applied, were unlawful, since they violated a company’s right to freedom of establishment.  By imposing UK tax rates on a company lawfully incorporated elsewhere in the EU, the UK was denying companies the right freely to establish themselves in another EU country where, provided they are carrying on genuine economic activity, i.e. bearing the risks and rewards of operating in that country they ought, by rights to suffer the local tax rate.

However, this case was only a partial victory for Cadbury Schweppes.  The ECJ left it to the Special Commissioners to determine the extent to which Cadbury Schweppes Overseas Limited was in fact carrying on genuine economic activity, providing guidance on how this determination ought to be made. 

The ECJ considered that whether the CFC is an “actual establishment” carrying on genuine economic activity, should be determined not solely by reference to subjective factors, but by reference to objective factors such as the existence of premises, staff and equipment. The UK rules as they stood included the “motive test” (an exception to the CFC rules which broadly provides that the CFC rules will not apply where tax avoidance is not the motive for the incorporation or activities of the subsidiary).  However, determining the motive for incorporating a subsidiary in an overseas jurisdiction is a subjective matter, and therefore, could well be outweighed by a number of clear objective factors (presence of an overseas office, overseas management, overseas employees, decisions taken overseas.)

How the Cadbury case influenced the Vodafone case

In the Vodafone case, the UK High Court considered whether it was within their power to determine in this case that the “motive test” should be considered an objective test, and therefore, a relevant factor in determining whether UK CFC rules should trump the right to freedom of establishment.  The High Court determined that the motive test does not include an objective test and that to re-interpret it as doing so would be to move from interpretation into the creation/amendment of legislation.  Since the role of the national court is to interpret legislation rather than to create or amend it (that being the role of parliament) the High Court found that in the Vodafone case too, the EU right to freedom of establishment trumped the UK CFC rules.

Conclusions

Returning, then, to the assumptions underlying Private Eye’s £6 billion estimate, are they met?  I would say that the first assumption is met, that the subsidiary in question is a CFC.  However, the second assumption is explicitly not met, since the High Court found that the in this case, as in previous cases, the UK CFC rules could not be applied in the EU without violating the company’s right to freedom of establishment.  Does Vodafone owe £6 billion in unpaid tax? Almost certainly not.  But if you want to argue with this, your argument is with the court that determined that a company’s motives in setting up a CFC are a subjective matter and therefore cannot be used as the winning argument that allows UK CFC rules to trump EU freedom of establishment rules.

For that reason, I think the protesters should have left the Vodafone UK stores alone.

Note: using a company incorporated in a low tax territory to reduce the group tax bill

The way in which the tax structure in question would seem to operate is that a UK company owes an amount to a Luxembourg company.  The UK company pays interest, enjoying a tax credit at the UK large company rate, say 30%.  Meanwhile, the Luxembourg company suffers a tax charge at the lower Luxembourg rate, say, hypothetically, 10%.  On consolidation, the interest charge and income disappear (the group has paid the interest to itself) but the credit against taxable profits in the UK is higher than the tax charge in Luxembourg, resulting in a reduction in the overall cost of tax to the group.

If this seems like free beer, bear in mind that for the UK company to lend to the Luxembourg company, we might suppose that the Group is financing itself externally (e.g. from a bank, from equity) in the UK at UK cost of equity and debt, rather than in Luxembourg at Luxembourg cost of equity and debt.

Sources

Practical Law Company, July 2008
Practical Law Company, September 2006