Controlled Foreign Companies: EEA states - deduction for net economic value against apportionment: “Net economic value” created directly by work in an EEA state
In concluding that the controlled foreign companies’ rules are an appropriate means of tackling tax avoidance within the EU, the ECJ distinguished between:
- Groups genuinely exercising their freedom to establish anywhere within the EU by (re)locating genuine economic activities to another Member State (not tax avoidance even if only done so as to benefit from low tax rates); and,
- Groups diverting profits from elsewhere to a controlled foreign company in another Member State, without locating in that Member State the genuine economic activity creating those profits (tax avoidance).
The ECJ gave broad guidance on what it meant by “genuine economic activities”, which concentrated more on what they were not (e.g. activities that “do not reflect economic reality” or activities that involve “practices which have no purpose other than to escape … tax”) than what they were.
The distinction is in essence one between the creation of profits in another Member State and the diversion of profits to another Member State from elsewhere. And in relation to a controlled foreign company the distinction is, in essence, between profits, that arise from undertaking work in a business establishment in the other Member State and those that arise from holding assets. Profits created by work normally arise where the activities are located. Profits from holding assets are mobile and derive from ownership. They have no necessary tie to where activities take place.
By undertaking work on a long term basis in a business establishment in another Member State, a group participates, on a stable and continuing basis, in the economic life of the other Member State.
For the purposes of these rules and in respect of profits not already exempt because one of the existing exemptions in the rules applies, the profits identified as arising from “genuine economic activities” undertaken in another Member State are those created directly by the work of the individuals working for the controlled foreign company in its EEA business establishment(s).
Profits from holding assets are not profits created by the work of individuals working for the controlled foreign company. Profits from holding assets includes any amount of profits arising in a controlled foreign company as a consequence of locating non-essential equity capital in the controlled foreign company, for example where a group chooses to use equity rather than debt to finance the activities of the controlled foreign company.
Further, arrangements that are entirely intra-group and, of themselves add no value to the group (e.g. intra-group lending) cannot give rise to profits of “genuine economic activities”. By definition, they simply move value from one part of the group to another. (This is in contrast to intra-group service provision comprising part of the work involved in delivering the group’s business; such work can create value for the group as a whole.)
The new rules make the necessary distinction (on the grant of an application under the new rules) by excluding from a controlled foreign company apportionment that part of a controlled foreign company’s chargeable profits that represents the “net economic value” to the group arising from the work carried out by the controlled foreign company’s staff in the company’s business establishment in the other Member State.
The “net economic value” is the real economic profit to the group as a whole created directly by the work of individuals working for the controlled foreign company in an EEA state, after allowing for the full economic costs to the group of carrying out the work.
The focus is on real economic value created by the work, before any tax reduction (see ICTA88/S751A(5)), though once the appropriate amount has been established, a controlled foreign company can benefit from any low local tax rate applicable to that amount of the company’s profits.
The value of the work must be assessed in relation to its actual content and the competence and level of independence/authority of the person carrying out the work. For example, work that has minimal content and nominally (or notionally) relates to capital or other assets placed artificially in the controlled foreign company may have some intrinsic value; however this value will be limited and very marginal when compared to the value of the profits that arise from holding the capital or other assets. In such circumstances, the profits in the controlled foreign company largely come from the diversion of profits to it, rather than those profits being created by its work. Such diversion of profits may be achieved, for example, by placing capital or other assets, such as intangible assets, in the controlled foreign company; or by arranging for capital to accumulate in a controlled foreign company, or ownership of new intellectual property to arise in a controlled foreign company. Such profits do not constitute “net economic value” to the group created directly by the work of the staff in the controlled foreign company.
A useful guide is that the “net economic value” should equate to what the group would be prepared to pay to a third party to undertake the work done by staff working for the controlled foreign company in the relevant state(s), over and above the full economic costs of undertaking the work.
INTM256040 illustrates the application of the rules to different scenarios, including examples of methods that could be used to quantify the “net economic value”. (Documentation requirements are discussed at INTM256080)