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Controlled Foreign Corporation (CFC) taxation in Sweden and new “business purpose” test.

 

by Peter Sundgren

 

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Contents:                                                                                                         Page:

 

Historical Background…………………………………………………………………….……....1
Compatibility of our CFC taxation rules with the EU Treaty…………………………………..3
Cadbury Schweppes and the “business purpose” test……………………..…………………….5
The concept of “business purpose” in Swedish tax law……………………………………….....6
Relationship between Member State anti-avoidance measures and Community
Law…………………………………………………………………………………………………..8
Disregard of legal entities for tax purposes…………………………………………………….....9
Permanent establishment of a wholly artificial CFC…..…………..………………....................10
Swedish held CFCs in the European Community……………………………………………….11
Cadbury Schweppes and the future………………………………………………………………11
The “Columbus Container” case……………………………………………………………….... 13
Conclusions………………………………………………………………………………………....14

 

 

 

 

Historical background

 

With flags flying and proud declarations to protect the Swedish tax base, Sweden launched its first CFC taxation regime in 1991. Very soon, however, it was discovered that, instead of counteracting abusive international tax planning, the new regime actually developed into a very efficient and lucrative instrument for such purposes! The main reason here for was  that whereas the rules took indirect holdings into consideration for the purpose of determining control over the foreign company they only applied as such to first tier investments in non-treaty states. Therefore, in order to avoid CFC taxation, low tax and tax haven companies, which would have been subject to CFC taxation if held directly by a Swedish shareholder, would simply be set up as subsidiaries to holding companies in tax treaty states. Also, which gave rise to further and quite substantial tax base erosion (due to the idea that foreign CFCs should be taxed as foreign partnerships), losses of CFCs were fully deductible against the income of the Swedish controlling company. Only after a number of years was the embarrassment of this legislative “mistake” corrected. By that time, according to Tax Administration estimates, treasury losses had risen to about 8 billion SEK.

 

In the early 2000s a new round of CFC legislation, effective January 1, 2004, took place, mainly in order to coordinate it with our new participation exemption regime.

 

The main features of these new CFC taxation rules which are still in force are as follows:

  1. They kick in at a level of ownership or voting power of 25% or more of the foreign corporation. Most important is that also second and third tier etc. foreign companies now fall under CFC treatment.
  2. The income of the CFC, assessed under Swedish rules for business income (with some minor exceptions), is taxed in Sweden in the hands of the shareholder if the tax levied in the foreign jurisdiction is less than 15.4% (corresponding to the Swedish corporate tax of 28% on 55% of the income).
  3. The (underlying) tax levied in the foreign jurisdiction on the CFC is creditable against the Swedish tax payable by the shareholder.
  4. There is a comprehensive list covering every country in the world under which CFCs are either subjected to tax assessment in Sweden according to section 2 above or, and most importantly, completely exempted from CFC treatment regardless of any low taxation.[1]

 

The lists mentioned above (under 4) have the advantage of providing almost absolute predictability. In most cases, with a map of the world in one hand and the CFC list in the other, it is thus immediately possible to foresee if a foreign company will be targeted for CFC taxation in Sweden or not.[2] The white list is very extensive comprising no less than 153 countries. And there are numerous companies in these countries that are taxed at rates far below 15.4%. The blacklist covers only 54 countries, almost all of them notorious tax havens. The grey list which targets only  low-taxed CFCs engaging in inter-company financial services, banking or insurance  activities but excludes all other types of businesses, covers 21 countries out of which 7 are EES-countries.  

 

Therefore , in effect, the number of CFCs affected by our CFC tax regime, except those that have been set up in pure tax havens, is extremely small.[3] There seems to be very little ongoing litigation on CFC tax matters. Probably it is thus fair to say that Sweden’s CFC taxation regime is among the most lenient in the world. My own experience of Swedish controlling shareholders that have effectively been subjected to CFC tax treatment is nil. But I have advised a number of clients of how to avoid CFC taxation. And this is maybe the only economic result of our CFC tax regimes - they keep lining the pockets of us tax practitioners![4]

 

It also appears that the approach by the finance department and the tax administration to CFC taxation is quite lackadaisical. The Government bill from 2004 devoted no less than a full page to the requirement that the tax administration should carefully follow up the practical experiences of the new CFC legislation and report back to the finance department no later than June 30 2007. A recent request (by me) for a copy of this report gave rise to quite some consternation at The National Tax Administration (Skatteverket) which finally declared that no such report existed! They blamed the finance department for not having followed up their intention in the Government Bill with a formal request for the report. And the present finance minister blames the Government of the former and ousted social democratic party for the negligence. So the contrast between the high-flying declarations to protect the Swedish tax base and the indifference in practice to do so is stark.

 

Consequently, our CFC regime so far has probably been of more interest to fiscal law professors, scholars and other tax analysts in general  than to tax payers.

 

 

Compatibility of our CFC taxation rules with the EU Treaty.

 

Our rules on CFC taxation have never made any exception as such for CFCs in the Member States of the European Community.[5]

 

This, in the run-up to the 2004 legislation, gave rise to a very vociferous and uncompromising reaction from academic circles and strong corporate tax  payer lobbies as being in conflict with basic Community rules of free establishment under articles 43 and 48 of the EU Treaty. See articles by professor Nils Mattssons published in Svensk Skattetidning in Skattenytt no 4/2004, Jur.Dr. Lars-Erik Wenehed in IUR/INFO, no 1/2004 and Gunnar Rabe of the Federation of Swedish Enterprise  in Skattenytt nr 1-2/2004.

 

I, on the other hand, (like a Don Quijote), defended the Swedish Government’s position that the Swedish CFC rules did not violate the Treaty. The article that I produced hereon was, however, and to my great disappointment, denied publication in the Swedish tax periodicals. (It was subsequently published in my own Webb-journal on International Taxation in Sweden no 1/2004, in Swedish only). More hereinafter.

 

Interesting to note in this context was that the Government Bill actually devoted no less than sixteen pages to the CFC regime’s relation Sweden’s international commitments. This is quite extraordinary because it is always taken for granted that the Government never proposes legislation which violates such commitments!

 

At a seminar in late 2003 arranged by the Swedish IFA Branch to discuss the new CFC legislation and professor Nils Mattsson’s (draft) article , Sweden’s no doubt most influential authority on international taxation, Professor Emeritus Leif Mutén even went so far as dismissing the Government’s opinion as representing nothing but “pure pettifoggery” (ren brännvinsadvokatyr)! Further, at a meeting with The Tax Law Club (Skatterättsliga Klubben) in early 2004 professor Sven Olof Lodin, former Head of the Tax Department of the Federation of Swedish Industries and ex-president of the International Fiscal Association, sharply criticized the Government for having presented the new CFC regime without considering the expertise that had rejected it as being non-compatible with the EU Treaty. Mr. Krister Andersson , who is present Head of the taxes at the Confederation of Swedish Enterprise, also slated the legislator for its CFC policies in an article in Svensk Skattetidning  (2004 page 72), mockingly titled “CFC-rules as a means for reducing prosperity”.

 

With the advent in 2006 of the Cadbury Schweppes plc. ruling (C-196/04) by the ECJ, the matter has now been resolved in favor of the opinion professed by Professor Mutén et consortes. And I (slightly tipsy from too much brännvin)  have found that the “lance I drew” for compatibility of our CFC regime with EC law is broken!

 

The ECJ has thus concluded that taking advantage of a low tax rate in a Member State in itself cannot be qualified as an abuse of Community law. It also found that the UK’s CFC regulations were indeed in violation of the principles of free establishment within the community according to articles 43 and 48 of the Treaty unless, however – and this is what has attracted everybody’s attention - the legislation is limited to apply only to “wholly artificial arrangements” designed to avoid the national tax which is normally due. The ECJ emphasized that an actual business of the CFC must be performed in the host Member State for an indefinite period. The Court described this as an endeavor to assist in the economic and social interpenetration within the Community by means of establishing a subsidiary in the host Member State. That finding had to be based on objective factors that are ascertainable by third parties, in particular with regard to the extent to which the CFC physically existed in terms of premises, staff and equipment.

 

In compliance with the Cadbury Schweppes ruling a third round of CFC legislation (Government Bill, Prop. 2007/08:16) has taken place and become effective as of January 1, 2008. [6] These new rules will probably clear most low-taxed CFCs established in the seven EES-countries on our grey-list from CFC taxation in Sweden. The new legislation also brings with it very interesting aspects of Community law and possibly also anti-tax avoidance matters in general. The remainder of this report will provide some thoughts hereon.

 

The main feature of the new rules is that the income of a CFC which has been set up by a Swedish shareholder within the European Economic Space (EES) – the Member States plus Iceland, Norway and Liechtenstein - shall not be considered to be taxed at a low rate of tax (for the purposes of our CFC legislation) if the shareholder can prove that the CFC represents a “real establishment engaged in genuine business operations” (en verklig etablering från vilken en affärsmässigt motiverad verksamhet bedrivs). The purpose of the establishment of the CFC must be to participate and assist for an indefinite period and for economic gain in the commercial and economic environment of the Community and not just for the purpose of achieving tax benefits.

 

This corresponds broadly, it is suggested, with the so called “business purpose” doctrine developed mainly in common law countries, which requires that a tax payer have a reason other than the avoidance of taxes for undertaking a transaction or a series of transactions.[7] Only if the investor furnishes proof to this effect will he escape the CFC tax treatment of the Member State.

 

 

Cadbury Schweppes and the business purpose test

 

This is the first time, at least as far as international taxation is concerned, that a business purpose test has been introduced and some of its criteria carefully chiseled out in Swedish tax legislation (Chapter 39 a, paragraph 7a of the Income Tax Law).

 

The purpose hereof is thus (page 21 of the Government Bill) to determine whether the foreign company constitutes such a “wholly artificial arrangement” as mentioned in the Cadbury Schweppes case. All relevant circumstances are to be taken into account. Some of these, however, have been considered typically indicative of whether the establishment is of such a “true” or “real” economic nature required. Thus, the new Swedish rules, emulating the ECJ ruling, prescribe that the CFC have its own premises in order to distinguish it from so called letterbox companies in which the company only has a postal address and that it have requisite equipment for carrying out its responsibilities. (The reference to letterbox companies seemingly gives rise to the presumption that such companies are always wholly artificial!) As further evidence of the existence of a “real” establishment, attention is focused on the presence of sufficient and suitably competent personnel of the foreign corporation and that the day to day operations thereof shall be carried out independently by them without the influence or involvement of staff from the CFC’s parent company or any other company within the business group.

 

During the legislative process there has been an impassioned discussion within tax practitioner circles as to whether the Swedish text “a real establishment engaged in genuine business operations” (en verklig etablering från vilken en affärsmässigt motiverad verksamhet bedrivs) actually conforms to the meaning of  a “wholly artificial arrangement” used by the ECJ in Cadbury Schweppes. Several commentators have thus argued that the latter expression is much narrower than the text of the Swedish law.[8] The Swedish government, however, has dismissed this criticism and stressed that a wholly artificial arrangement is indeed characterized by its absence of business purpose. The Swedish expression thus serves to  elucidate the meaning of a “wholly artificial arrangement”. The Government admits that the terminology of the Swedish text to a certain degree differs from that of the ECJ in Cadbury Schweppes but concludes that its business purpose/motivation test does not impose further demands than those of the ECJ in Cadbury Schweppes. Moreover, a Member State when adapting its legislation to ECJ rulings is not obliged to use the exact terminology in its domestic legislation as that used by the ECJ. The important thing is that the principles of its rulings are appropriately reflected in the national laws of a Member State.[9] The Government further emphasizes that later judgments by the ECJ, indeed, with special reference to Cadbury Schweppes, have used the term “business reasons”. One such ruling is C-524/04 (Test Claimants in Thin Cap Group Litigation versus Commissioners of Inland Revenue, REG 2007 I-0000) concerning the UK thin capitalization rules. In this judgment the ECJ concluded that the tax payer in all situations where a fictitious arrangement cannot be ruled out shall be given the opportunity to provide information regarding all business reasons that have justified the arrangement. Also, in ruling C-231/05 (OY AA, REG 2007 I-0000) regarding the Finnish group contribution rules, the ECJ expressed its views regarding  the creation of fictitious arrangements that lack business purpose. In these two rulings the ECJ thus establishes the connection between fictitious or artificial arrangements and the absence of business motivation.

 

An analysis of these arguments thus leads to the conclusion that the liberties within the Common Market on free establishment, free movement etc. are available for tax purposes only so long as the underlying behavior of the EU citizen is justified by other than tax considerations. The repeated reference hereto by the ECJ, it must further be understood, reveals the existence of a general principle in this regard always to be considered by the judge regardless of whether or not it is expressly postulated as such in the pertinent legislation.

 

 

The concept of business purpose in Swedish tax law.

 

In contrast to the tradition of many common law countries, the experience we have from legal practice in Sweden of such doctrines as “business purpose”, “commercial motive” and “economic substance” all of which according to Anders Hultqvist[10] can be considered synonymous with the more general term “non-tax purpose” as anti-avoidance measures in tax matters is quite limited. It is therefore very interesting to observe how these principles are now “nestling” their way into our tax system by “command” of the ECJ!

 

This, however, is a development which is to be welcomed considering the ever increasing aggressiveness of tax planning which, in my experience, so often is completely denuded of any business purpose considerations. In both domestic and international corporate tax planning it is especially common that, in order to achieve the intended avoidance of tax, various (and sometimes quite many) companies are set up for these purposes. Only very seldom are other than the tax avoidance purposes considered in these situations. A quite provocative example of such an arrangement occurred in the mid 90s when the family members and (controlling) shareholders of the large Spendrup company, which is listed on the stock exchange, in a lightning series of transactions transferred their shares to a personal Liechtenstein trust, setting up in the process and, as it appeared, immediately closing down no less than sixteen companies in various tax haven and other suitable tax jurisdictions. [11]

 

A further arrangement involving the setting up of a company  which has been stirring up a lot of controversy in Sweden is the so called “interest spinner”. Apart from the tax advantages derived from the company’s receipt of a group contribution from a Swedish company being offset by a deduction for an interest payment to a tax haven group company the further economic substance of the company formation can be quite obscure. Thus, the Tax Administration concluded that the formation of the interest spinning company, apart from its tax advantages, was completely meaningless from a business purpose point of view.

 

The trend of encouraging business purpose considerations in tax matters seems to be growing with regard also to general anti-avoidance rules (GAAR) and other look-through or similar anti-avoidance approaches. In the summing up of her recent (and quite brilliant) doctoral thesis on our GAAR[12] Ulrika Rosander, at the Jönköping International Business School, has strongly recommended (page 248) that Sweden should emulate the Canadian experience  of allowing the adoption of “economic substance” as a supplementary means for the understanding of our GAAR. She recognizes the difficulties involved herein but nevertheless concludes that it is possible and indeed easier to determine the criteria for “economic substance” than those for establishing the elusive meaning of “the purpose of the legislation” which presently is the defining element of our GAAR. She rejects the problems of the reversed burden of proof (page 249) and its impact on the legal security of the tax payer, convincingly arguing that this will affect only transactions where there is no economic substance. Quite boldly she even suggests that taxpayers engaging in transactions that lack economic substance should not be entitled to the same degree of legal security!

Another influential and strong supporter of “economic substance” in tax avoidance matters is (the Tax Commission of) the International Chamber of Commerce (ICC) in Paris that “speaks for the whole international business community in dialogue with governments and intergovernmental organizations on developments in international tax policy and legislation”. In a policy statement of  June 27, 2000 on “The Application of Anti-Avoidance Rules in the field of taxation”, the Commission (of which I at the time was a member), in what was generally a very critical review and rejection of  the growing tendency of tax authorities in many countries to re-characterize or disregard transactions in tax assessments based on interpretations of their Anti-Avoidance Rules, nevertheless concluded, that to the extent that such rules (or abuse of law or its equivalent) are adopted,  the application thereof “should be limited to exceptional cases in which there is no economic substance and no substantive business reason for a transaction (emphasis added). Economic substance is a business test based on all facts and circumstances of a transaction and mechanical tests should be avoided”.

An important development is currently also taking place in Germany regarding “business purpose” in tax avoidance matters. The German Government is thus presenting a tax bill in which it, with regard to the anti-avoidance clause in section 42 of the German General Tax Code (Abgabenordnung), is incorporating a definition of “abuse”. This term will be defined as an unusual legal arrangement that results in a tax benefit for which no valid non-tax reason exists. As a result, if the tax authorities can prove that a legal arrangement is unusual, the tax payer will have to demonstrate the existence of non-tax reasons for the approach taken. An arrangement or structure will be considered “unusual” if it is inconsistent with what the legislature, in applying generally accepted views, assumed would be employed to achieve certain economic aims.

It will be very interesting to see to what extent the principles of  “business purpose” and “economic substance” will have an impact on our tax courts in the future.

 

Relationship between Member State anti-avoidance measures and “abus de droit” under Community Law.

In the Bill to the Swedish CFC legislation which has now been put in place the Government has been engaged in a discussion about the relationship between the CFC legislation and our GAAR. It agrees in principle with the opinion of the Swedish Bar Association that the latter rule is consistent with the views of the ECJ of what is possible for the national legislator regarding the prevention of tax avoidance and that nothing should thus prevent the GAAR from being applied to cross-border situations within the Community. Nevertheless, concludes the Government, the specific CFC rules are necessary to address the special situation that occurs in these regards.

Stig von Bahr, a former judge of both the Swedish Supreme Administrative Court and the ECJ, in a recent article regarding tax avoidance and Community law[13] including also an analysis of Cadbury Schweppes, has demonstrated that the ECJ maintains a strong aversion to the acceptance of  artificial arrangements on formal grounds. He further concludes with regard to non-harmonized legislation such as direct tax legislation that, if a transaction/arrangement within the Community constitutes “pratique abusive” or “abus de droit” (förfarandemissbruk/rättsmissbruk) under Community law, the liberties provided under the EU Treaty such as for instance the right to free establishment are not available.  The Member State is thus free to impose whatever measures it sees fit to counteract tax avoidance of whatever kind. If, however, with regard to inter-community transactions/arrangements, the tax payer can convincingly demonstrate that he has sound business or other non-tax motivations for his behavior and that there is no “abus de droit” under Community law the Member State cannot enforce its domestic anti-avoidance legislation or other measures of such nature.

An even more interesting question is, if an inter-community transaction is considered “wholly artificial” under Community law and thus not entitled to Community privileges but is not caught by any domestic Member State anti-avoidance measure, can then the Swedish court invoke the EU’s “abus de droit” to declare the transaction as tax avoidance? Under all circumstances it would seem quite unsatisfactory if a wholly artificial arrangement preventing the tax payer to invoke EC Treaty privileges would escape domestic Member State anti-avoidance intervention. If so, it would be appropriate that Member States adapt their anti-avoidance regimes so that they comply with the ECJ.

 

Disregard of legal entities for tax purposes

 

Also to be taken into account, generally, as far as CFCs are concerned and demonstrating, too, that our courts are not completely unaffected by business purpose considerations in anti tax-avoidance matters is the principle of “disregard of a legal entity for tax purposes”. This was a topic to which a ‘full’ IFA congress was devoted in 1989 in Rio de Janeiro.[14] The relevance of this principle with regard to CFC taxation is of course that the very nature of such taxation embodies a disregard for tax purposes of a legal entity! CFC taxation represents a “look-through rule” imposing tax upon the shareholder as if the CFC did not exist. As emphasized in the 1989 Swedish national report the principle itself of disregard of a legal entity has been widely accepted by the Swedish Supreme Administrative Court. In an international tax context two specific rulings RÅ 1969 fi. not 1084-1087 and RÅ 1969 not 1591 were quoted where such disregard occurred. In both cases the Court, for reasons that can be assumed as adopted for nothing but the total absence of business purpose, disregarded (looked through) an arrangement where a Swedish company, dealing under arm’s length requirements with a foreign subsidiary, had set up an intermediate Swiss re-invoicing company in Switzerland for the sole purpose of stepping up the acquisition cost of certain equipment delivered by the first mentioned subsidiary, denied the Swedish company a deduction of the marked-up price of the Swiss company. The interesting point about these cases is that the Court did not apply the (normal) rules for adjusting non arm’s length prices but went so far as disregarding the Swiss company completely for tax purposes. The Court did not even bother to consider whether the price determined by the Swiss company was at arm’s length! The explanation hereto, it must be assumed, was that the establishment of the Swiss company was indeed “wholly artificial”, the only purpose of it being to re-invoice and jack up the price to be paid and deducted by the Swedish company. It demonstrates that the Court does certainly not ignore business purpose as a means to combat tax avoidance. Therefore, possibly, the “disregard principle” could be applied to a wholly artificial foreign (controlled) company where ever it may be established regardless of any CFC tax law!

 

The discussion in Sweden has been quite intense – Ulrika Rosander’s work is a good example hereof – as to whether, beside the GAAR, other legal practice methods such as “look-through” etc. for repressing tax avoidance are recognized in Sweden[15]. Apart from the national report thereon from the 1989 IFA congress the principle of disregard of legal entities for tax purposes has, however, has attracted little attention. Maybe it is time for a revival hereof.

 

 

Permanent establishment of a wholly artificial CFC

 

If a foreign CFC is considered “wholly artificial” because it has neither premises nor personnel nor equipment etc. in the pertinent Member State consideration should also be given to the question whether such a CFC has a permanent establishment in the state where it has been set up. Where, one must ask oneself, is the business by such a CFC carried on. Because it must be assumed that a CFC even if it is wholly artificial in its host state must nevertheless have a permanent establishment somewhere!  In many such cases one may conclude that the CFC, to quote article 5 of most tax treaties, has “a fixed place of business through which its business is wholly or partly carried on” in the country of the controlling shareholder because it has its “place of management” or “office” located there.

 

In these cases one would of course not need any CFC rules. One would simply subject the foreign CFC to taxation in the state of the shareholder because it has a permanent establishment there, effectively attaining the same tax result as a CFC taxation! The only difference is that the tax is borne by the foreign CFC and not the shareholder. Interesting to note is indeed the fact that the criteria for determining whether or not the foreign CFC is a “real” establishment according to the ECJ are very similar to those for determining the meaning of “permanent” establishment according to the OECD (Model Treaty), i.e. that the enterprise shall have an office or other fixed base of business, a place of management etc. at its disposal in the pertinent country.

 

A consequence of such a solution would mean that one would not run into any problems caused by the EU rules on free establishment etc. and it would also absolve the taxing (permanent establishment) state of giving credit for any foreign taxes!

Worth noting, however, is that in these cases the tax administration will have the burden of proof  for securing the primary taxing right of the permanent establishment state.

 

 

Swedish held CFCs in the European Community.

 

The CFCs in the Cadbury Schweppes case were two subsidiaries in Ireland that took care of the group’s financing activities the profits of which were geared to be favorably taxed under the so called “International Financial Services” tax regime in Dublin. It is understood that these specific Irish subsidiaries were finally cleared by the UK court of reference as genuine/real investments and were thus not considered wholly artificial. This is not surprising as the kinds of activities performed by these types of finance companies are generally, it is suggested, of such a nature that they indeed require physical presence by a qualified staff, offices and business equipment etc.

 

As already mentioned Sweden’s CFC taxation of Member State companies applies only vis-à-vis  seven EU and EES states (Belgium, Cyprus, Estonia, Iceland, Ireland, Luxembourg and the Netherlands).  In addition, and which has also been noted, such taxation comes into play only with regard to banking, finance, insurance etc. activities but not with regard to companies involved in “normal” business operations nor foreign holding or passive investment companies owned by Swedish investors. Such companies are white-listed regardless of how little tax they pay.

 

A Swedish held CFC engaging in such (financial) activities as just mentioned is thus  likely to be considered as such a real establishment engaged in genuine business operations required by Cadbury Schweppes and our new CFC taxation rules. Therefore it can be anticipated that the number of cases where Swedish CFC taxation with regard to European CFCs will finally take place will be extremely small. Considering, however, the inexperience in Sweden regarding the meaning of  such expressions as “wholly artificial”, “business purpose” etc. it can also be expected that many of those investors that are affected will nevertheless seek advance ruling guidance in these matters. A reason here for is of course that the types of activities in which these low-taxed companies are engaged will invariably involve very large amounts of money.

 

Cadbury Schweppes and the future.

As already explained above the bottom line of the Cadbury Schweppes ruling is that a tax payer where ever resident in the Community may freely enjoy a low taxation of his foreign income derived in the Community without that income being subjected to a higher level of taxation in his home jurisdiction by way of a CFC taxation regime. Professor Mattsson in his article in Skattenytt was also quite clear on this point: “If a Member State were permitted to frustrate the tax payer’s right  to enjoy an advantageous tax climate in another Community State by adding on a higher tax in the state of his residence the principle of free establishment in my opinion would lose all reasonable credibility.”

The only condition for a Member State to enforce a CFC tax is that the transactions or activities giving rise to the income are based on wholly artificial arrangements or, as determined in the framing of our new Swedish CFC rules, that the CFC does not represent a “real establishment engaged in genuine business operations”. If therefore the investment in the CFC is based on sound business or commercial reasons the imposition of an (additional) and higher tax in the home country of the investor constitutes a violation of his liberties of free establishment and free movement etc. which is guaranteed under the EU Treaty.

If so - and this was the argument I high-lighted at the 2003 IFA Branch meeting and wrote in my subsequent Webb-journal article in 2004 - what would happen if a Swedish company or a Swedish resident individual instead of setting up a CFC in a low tax EU jurisdiction were to use a permanent establishment or a partnership in that same jurisdiction for his investment? The income of such a permanent establishment or foreign partnership, with very few exceptions in certain tax treaties applying the exemption method, is subject to tax in Sweden and a credit is provided for the foreign tax.

For all practical purposes such a permanent establishment or partnership would consequently be subjected to exactly the same taxation as a CFC. A significant difference is of course that the taxation of a foreign permanent establishment or a partnership is even more severe in that it applies regardless of the level of tax in the host country or the level of participation in the investment.

Consequently, if the setting up of the permanent establishment or a partnership in the EU is not wholly artificial, should not Sweden’s rules of subjecting the income of the permanent establishment or partnership to taxation in Sweden according to its normal credit of foreign tax rules for relieving double taxation also be considered to be a violation of the Treaty? What is the difference between this situation and Cadbury Schweppes? Why should not the investor be allowed to enjoy a lower tax in the (EU) of a permanent establishment or a partnership just like the investor using a CFC in that same country? Surely they must enjoy the same liberties as a limited liability CFC.

And why stop at company taxation! Consider for instance a Swedish resident board member of a company in another EU state collecting a director’s fee for his services in that company or a Swedish golf professional earning prize money from a tournament in another Member State. Such incomes are invariably subject to primary taxation in the state of the company and in the state of the golf tournament respectively, usually at a much lower rate of tax than that in Sweden. Could then such a director or golf professional invoke Cadbury Schweppes to prevent such taxation in Sweden?

In this light Cadbury Schweppes casts a shadow on the very foundations of basic principles of international taxation! Thus, it brings into doubt the applicability of the capital export neutrality principle as such and indeed also the credit of foreign tax method as a means for relieving double taxation. Professor Wolfgang Schön of the Max Planck Institute in Germany in his British Tax Review article (2001, no 4) on “CFC Legislation and European Community Law” expressed this opinion very unequivocally: “It is submitted that those who take the view that capital export neutrality cannot be reconciled with the basic ideas of the Common Market should ask themselves whether they also consider the credit method contrary to the Treaty”.

 

The “Columbus Container” case.
It is unfortunate that the capital export neutrality problem was not even addressed in Cadbury Schweppes. Everyone just concentrated on the "abuse" topic so a more systematic approach was missed.
In the recently adjudicated ECJ case regarding Columbus Container Services BVBA & Co (C-298/05) this issue has now been resolved. In this case the German Tax Authorities had applied a domestic anti-avoidance provision in its Aussensteuergesetz whereby the exemption system, even when a tax treaty was applicable, may be exchanged for a credit of foreign tax and imputation system if a foreign investment, which in this case was a partnership in Belgium to be taxed in Germany as a permanent establishment, had obtained a Coordination Centre Tax Regime ruling and was subject to a low tax (30 percent or less) in Belgium. According to information submitted by the Columbus company the replacement of the exemption method by the credit method had increased the tax burden of Columbus’ partners by 53%.
In the view of the Advocate General Paolo Mengozzi, in his opinion on March 29 2007, dovetailing the conclusions reached in Cadbury Schweppes, the enforcement of such a rule by Germany was considered contrary to the freedom of establishment principle in the Community, unless it was demonstrated that the investment in Belgium was wholly artificial and intended to get around Germany’s national legislation.
The ECJ, however, rejecting this opinion completely, came to the conclusion that article 43 EC “must be interpreted as not precluding tax legislation of a Member State under which the income of a resident national derived from capital invested in an establishment which has its registered office in another Member State is, notwithstanding the existence of a double taxation convention concluded with the Member State in which the establishment has its registered office, not exempted from national income tax but is subject to national taxation against which the tax levied in the other Member State is set off”.
An important argument in the ECJ’s reasoning (paragraphs 40 and 54) was that since partnerships such as Columbus did not suffer any tax disadvantage in comparison with partnerships established in Germany, there is no discrimination resulting from a difference in treatment between those two categories of partnerships. In this regard the Court affirms its position regarding the so called “migrant/non-migrant test” in e.g Terhoeve, Eurowings and Baars[16]
Columbus had declared that the provisions of the Aussensteuergesetz in issue lead to a distortion of the choice between different types of establishments. Accordingly, Columbus would have avoided application of those provisions if it had chosen to pursue its activities in Belgium through a subsidiary which was a company with share capital, and not through an establishment such as that in issue. In this respect, the ECJ responded, that it must be recalled that the fiscal autonomy embodied in double taxation conventions are designed to eliminate or mitigate the negative effects of the functioning of the internal market resulting from the coexistence of national tax systems.

 

Conclusions

As noted above our new rules on CFC taxation are likely to be useful for avoiding such taxation because the low-taxed companies in Europe targeted under our legislation in most cases will be able to prove that they are not wholly artificial. Taking into account too that the so called Code of Conduct between the Member States of the EU will completely eliminate the problems of low taxed corporations in Europe in the near future it could be worth while considering, as several commentators (including myself) have suggested in the past, to completely abolish CFC taxation in Sweden with regard to the Community.

As far as taxation of foreign permanent establishments is concerned Sweden, with the exception of a few tax treaty countries, adopts the credit of foreign tax method. Consequently the income of a foreign permanent establishment of a Swedish company is always subjected to tax in Sweden regardless of the level of tax imposed in the host country. Considering the quite favorable CFC tax rules in Sweden and the consequences of on the one hand of Cadbury Schweppes and on the other hand the Container Columbus cases the number of investments in foreign permanent establishments and partnerships in low-tax countries are likely to become quite negligible.

From a tax analyst’s viewpoint it will, however, be interesting to see, regarding Swedish CFCs in Europe, how the new “business purpose” and “economic substance” concepts will be applied by our tax courts and to what extent these principles in general will take further root in Swedish legislation and tax practice in the future. As discussed above it also paves the way for wider considerations regarding e.g. disregard of legal entities, permanent establishments etc.

Stockholm March 2008

peter@sundgren.net


[1] For more extensive information (in English) on Sweden’s participation exemption rules and the 2004 CFC taxation regime together with a comprehensive CFC black and white list of all countries in the world, see article by this author at www.skatter.se “Participation exemption and Controlled Foreign Corporation (CFC) taxation in Sweden – new instruments for international  tax planning”.

[2] It should be noted that this is a statutory list and that amendments thereto consequently can only be carried out by the Swedish Parliament. Foreign corporate tax changes that justify additions to or deletions from our CFC black or white lists thus give rise to a very complex legislative procedure (which will mean that changes will occur very seldom). Together with the new round of CFC legislation the Government has, however, taken the opportunity to call for CFC list changes regarding, (if I may be allowed to say so), the rather obscure countries of Bulgaria, Cyprus, Iceland, Morocco, Serbia-Montenegro and Hungary. Instead one should entrust the Tax Administration with the task of adjusting the CFC lists more informally on a current basis.

[3] It is possible, however, that there is a sizeable number of non-reported low-taxed CFCs in non-treaty countries which do not exchange tax information that should be subjected to CFC taxation, especially among such companies that were established before 2004.

[4] A further valuable tax planning point regarding Swedish individual shareholders of foreign CFCs is the possibility to defer the second level of the double taxation of company profits by borrowing the funds of the company. This is also widely exploited by Swedish shareholders of Swedish companies who, in the absence of any exit-tax rules, have expatriated their companies to foreign holding companies. Sweden has a rigorous criminal law forbidding shareholder/company loans but it applies only to Swedish companies. The tax authorities have demanded that similar rules be introduced for tax purposes regarding also foreign companies but this has so far been ignored by the tax legislator.

[5] In contrast, the 1991 CFC regime excluded all tax treaty countries which, at the time, also encompassed all of the Member States of the EU except Portugal. (Today, however, Sweden and Portugal are tax treaty partners.)

[6] It should be noted that there is no constitutional obligation for a Member State to formally implement ECJ rulings in its national legislation. Considering, however, the difficulties frequently involved in analyzing and interpreting such rulings and their practical consequences it is wise to do so.

[7] See US national report page 607 by William P. Streng and Lowell D. Yoder to the 2002 IFA congress on “”Form and substance in tax law”, Cahiers de Droit Fiscal International Volume LXXXVIIa.

[8] Cecilia Gunne, in a newsbrief from Burenstam & Partners (September 2007), even went so far as labeling the new legislation as a general amplification instead of a limitation of the Swedish CFC-regime!

[9] Germany is also in the process of adapting its Foreign Transaction Tax Law (Aussensteuergesetz) section 8 (2) to Cadbury Schweppes. Thus an income of a CFC will not be regarded and taxed as income of the German parent company if the CFC has its registered office or place of management in the EES and the tax payer can prove that the CFC carries on a genuine economic activity in the country in which it is resident.

[10] “Legalitetsprincipen vid inkomstbeskattningen”, Juristförlaget 1995.

[11] See articles hereon by this author in IUR/INFO no 1-2/2001 (in Swedish).

[12] ”Generalklausul mot skatteflykt”, JIBS Dissertation Series No.040

[13] Skattenytt nr 11/2007 sid 644- 651

[14] Cahiers de Droit Fiscal International, Volume 74b. 1989

[15] See also her national report to IFA’s 2002 congress in Oslo on ”Form and Substance in Tax Law”, (Cahiers de Droit Fiscal International 2002, Vol.87a.)

[16] C-294/97 (1997) ECR I-7447, C-18/95 (1999) ECR I-345 and C-251/98 (2000) ECR I-2787