A breach of rights

David Evans and Liam Delahunty consider the implications of the “abuse of Community rights” and anti-avoidance doctrines

Historically, most direct tax cases heard by the European Court of Justice (ECJ) have concerned individual taxpayers with “portfolio” investments, who have suffered clear breaches of their EC Treaty rights. These claimants have generally been successful.

Multi-national corporate taxpayers have seized upon this succession of victories and, over the last few years, a steady rise in claims by corporates - mostly successful - has been observed.

More recently though, claims by corporates - and ECJ judgments - have become increasingly complex, and the decisions in the D Case (C-376/03) and Marks & Spencer (C-446/03, M&S) may represent a turning point. Pending cases such as Cadbury Schweppes (C-196/04), concerning the UK’s controlled foreign company (CFC) rules, also raise complex issues.

It is therefore opportune to consider the doctrines of anti-avoidance (as upheld by the ECJ in M&S) and “abuse of Community rights”, which may provide member states with defences to what would otherwise be breaches of taxpayers’ EC Treaty rights. Let’s considers some of the more interesting cases of relevance.

Directly applicable community law cases

The first category of cases concerns directly applicable community law, such as the Sixth (VAT) Directive and EU regulations.

The Emsland (C-110/99) case concerned EU export regulations, under which Emsland was technically entitled to a VAT “export” refund for goods exported to Switzerland. These goods were immediately re-imported into another EU country.

The ECJ confirmed the existence of the principle of “abuse of rights” and found it has two requirements in the context of directly applicable Community law:

• the Community law’s purpose has not been achieved, although its formal requirements have been satisfied, and
• the taxpayer had the subjective intention to obtain an advantage from Community law by artificially creating the conditions for obtaining that advantage.

Therefore, the “abuse of Community rights” concept states that member states can prevent nationals from relying on their EU law rights in certain circumstances in which they were not intended to be available.

The ECJ did not reach a conclusion on the facts though, instead referring the matter back to the domestic court for a final decision.

Halifax (C-255/02) concerned a scheme under which the taxpayer claimed 100% input tax credits pursuant to the Sixth VAT Directive. Ordinarily, as it generally made exempt financial services supplies, Halifax would only be entitled to credits of approximately 5%.

The advocate-general again upheld the abuse principle, considering it operates as “principle governing interpretation of EC law”, and that, in each case, it will be necessary to ascertain the purpose of the relevant Community law and whether the right claimed falls outside this purpose.

However, where the right claimed takes place within the purpose of the relevant legislation, there can be no abuse by the mere legitimate exercise of that right, regardless of any artificiality. A final ECJ judgment is pending though.

Domestic law cases

This group of cases relates to domestic provisions where member states have defended otherwise restrictive domestic laws on the grounds that the claimant is abusing their EC Treaty freedoms, or on the basis they are justified on anti-avoidance grounds. Direct tax jurisprudence is limited, so two non-tax cases are considered as well.

In TV10 SA (C-23/93) Dutch nationals established a company in Luxembourg as a TV broadcaster, to broadcast to the Netherlands. The Dutch TV broadcasting rules regulated access to TV air time in the Netherlands for domestic broadcasters and imposed various cultural and non-commercial requirements.

The Dutch TV authority refused to allow TV10 SA to broadcast in the Netherlands, arguing it was established in Luxembourg by Dutch nationals, with the intention to evade these domestic requirements.

The ECJ upheld this refusal, essentially finding the Dutch broadcasting rules pursued a legitimate policy objective which TV10 SA was attempting to invoke its EC Treaty freedoms to artificially circumvent. The ECJ implicitly held this to be an “abuse” of TV10 SA’s Community rights, which the Dutch authorities were entitled to override.

In Centros (C-212/97), Danish nationals incorporated Centros Limited in the UK and purported to register a Danish branch. This avoided Denmark’s minimum capital requirements, which are intended to protect creditors. The Danish authorities refused to register the branch, claiming Centros was abusing its EC Treaty freedom of establishment, such that this freedom could be overridden.

Although the ECJ found for Centros, it held that: “A member state [may] take measures... to prevent… its nationals from attempting, under cover of [EC Treaty rights] improperly to circumvent their national legislation... or fraudulently taking advantage of provisions of Community law.”

The ECJ caveated this, holding that although member states may take account of nationals’ “abusive” conduct to deny the benefit of EC Treaty rights, they must assess such abusive conduct in light of the specific factual matrix, and the objectives the relevant provisions pursued

. In this case, the Danish domestic provisions had the legitimate purpose of protecting creditors. However, on the particular facts, Centros held itself out as a UK company so, arguably, those dealing with it should have known the minimum capital protection of Danish companies would not apply.

Considering these specific circumstances, the ECJ held the Danish authorities, by refusing to register Centros’ Danish branch, went beyond what was necessary to achieve the legitimate purpose of protecting creditors.

The ECJ noted that although Centros chose to form a company in one member state - whose corporate law was less restrictive than that of another member state - and then establish a branch in that other member state, this cannot by itself constitute an abuse of the EC Treaty freedom of establishment.

In its recent decision in the M&S case, the ECJ introduced a new “anti-avoidance” defence, which may justify restrictions on EC Treaty rights in certain circumstances. In contrast to the above cases, M&S does not concern “abuse” as there is no suggestion it purported to circumvent any law artificially.

M&S claimed the UK group relief provisions, in preventing it from obtaining relief in the UK for its EU subsidiaries’ losses, offended against its EC Treaty freedom of establishment.

The ECJ considered the UK rules did prima facie restrict M&S’ freedom of establishment, and that this would be permissible only if the rules pursued a legitimate purpose compatible with the Treaty, and did not go beyond what is necessary to attain that purpose (i.e. were proportionate).

The ECJ held the UK group relief rules, to the extent they prevented losses incurred by a subsidiary in another member state also being claimed in the UK - and being trafficked between high and low-tax member states - pursued the legitimate purpose of counteracting tax avoidance, and were, in general, a justifiable and proportionate restriction on EC Treaty freedoms.

Cadbury Schweppes

This case, which is pending before the ECJ, also raises complex questions of abuse and avoidance.

Interestingly, relying on the M&S judgment, the UK claimed in the oral hearing that if relocating losses to higher-tax member states constituted avoidance and could be legitimately restricted, the CFC rules’ objective of preventing the transfer of profits to lower tax jurisdictions should be justified for the same reason.

At the Special Commissioners’ hearing, though, Cadbury Schweppes advanced arguments that it had not established its low-taxed operations in Ireland purely for tax purposes and, by doing so, it should not therefore be regarded as engaging in tax avoidance.

The application of TV10 SA and Centros to Cadbury Schweppes also raises interesting questions - for instance, whether the CFC rules pursue a legitimate purpose, and whether the taxpayer’s conduct is “artificial”. These questions are largely subjective and, in particular, there is little guidance to date as to what constitutes “artificial” tax planning, so it is difficult to determine conclusively how the ECJ will resolve these issues.

Conclusion

In recent cases, particularly M&S, the ECJ has developed a more sophisticated and subtle approach in the direct tax context than that seen in earlier cases; this has been further evidenced in the D Case and Banca Popolare di Cremona (C-475/03).

It will be interesting to see whether this more subtle approach will be reflected in future cases, such as Cadbury Schweppes, where we may see questions of abuse and avoidance answered in more detail.

However, it is apparent that merely demonstrating differential treatment of taxpayers in the domestic context, as compared to the cross-border context, is not likely to be sufficient going forward, and more analysis will need to be done to establish legitimate claims.

David Evans is a tax director and Liam Delahunty is a tax adviser in Ernst & Young’s European Union tax group, which is part of International Tax Services. For more information, please contact David Evans (devans@uk.ey.com) or Liam Delahunty (ldelahunty@uk.ey.com).