The Court of Appeal recently found in favour of HM Revenue and Customs (HMRC) in the controversial case of Vodafone 2 v HMRC

The Court of Appeal has announced its findings in the 'Vodafone 2' case, an important case on the UK's Controlled Foreign Companies (CFC) legislation. What implications will this decision have for UK multinationals?

What does the CFC legislation aim to do?

The CFC rules apply to offshore companies that are owned by UK companies. The aim of the legislation is to prevent the avoidance of UK corporation tax on the profits of low taxed foreign resident, but UK controlled, companies.

What was the Vodafone 2 case about?

The case concerned whether the CFC rules should apply to a Luxembourg subsidiary of a UK company. In March 2000 Vodafone Group plc acquired Mannesmann AG through its wholly owned subsidiary Vodafone 2 Ltd (V2), a company incorporated and resident in England. As part of this process, V2 established a wholly owned Luxembourg subsidiary Vodafone Investments Luxembourg SARL (VIL). VIL served as intermediate holding company of Mannesmann AG and other European telecommunication companies.

HMRC argued that income earned by VIL should be taxed in the UK as result of the UK CFC rules.

V2 contended that CFC legislation did not apply for several reasons. One was that paying UK tax in respect of VIL profits would constitute an unlawful restriction on V2's freedom of establishment.

What was the decision made by the High Court?

The High Court agreed with V2 and ordered the disapplication of the UK CFC rules. It decided that the CFC legislation was not compatible with the EC Treaty in light of the European Court of Justice decision in the Cadbury Schweppes v HMRC case.

HMRC appealed the Court of Appeal decision.

What happened at the Court of Appeal?

The Court of Appeal upheld HMRC's appeal, finding that it was possible to adequately protect V2's EC Treaty rights without disapplying the CFC rules. It judged that the CFC rules should be interpreted as if it had a new additional exception, which applies with retrospective effect.
The new exception would apply to companies which:

• are 'actually established' in another member state of the European Economic Area (EEA); and
• carry on "genuine economic activities" there.

The Court of Appeal ruled that the normal CFC rules will still apply to companies operating outside the EEA and to EEA companies without genuine economic activities. The Court of Appeal however did not consider what qualifies as 'genuine economic activities'.
One point of discussion was whether the above change was a permissible interpretation of the statute, which is within the Court's remit, or the creation of new legislation, which is not within the Court's remit. It was held that it was an interpretation of the current law making clear that CFCs which are not artificial arrangements will be exempt from the CFC provisions, was an interpretation and therefore permissible.

What next for Vodafone?

An Appeal by Vodafone to the House of Lords is very likely. As such while companies who have made claims on the basis that the CFC rules are contrary to EU law may wish to review the claims in light of the Court of Appeal decision, in particular consider whether there was a genuine economic activity, we do not recommend any action is taken. For those who have not made claims but have suffered apportionment under the CFC rules for EEA subsidiaries, if the activities were genuine economic activities, consideration should be given to making a claim. It is worth noting that from 1 April 2010 such claims will be restricted to four years, so claims should be made before then in order to go back to earlier periods.

Roopa Aitken, International Tax Partner at Grant Thornton says "The judgment from the High Court was a convincing victory for Vodafone and a decision which would have had wide application to all EEA CFCs. The overturn of this decision by the Court of Appeal means that it will be necessary to consider facts of each case and consider whether the EEA subsidiary is genuinely established. Given the significance of this case, it is almost certain that the matter will now by heard by the House of Lords."

Please contact us if you would like further advice on any of the above.