The Cadbury Schweppes (C-196/04) case is a central ruling of the European Court of Justice (ECJ) on the application of the freedom of establishment under Art. 49 TFEU in the context of CFC rules (Controlled Foreign Company legislation).

The Cadbury Schweppes case was a landmark ruling in 2006 that dealt with the question of the compatibility of national tax regulations on CFC taxation with the fundamental freedoms of the EU internal market, in particular the freedom of establishment under Art. 49 TFEU.

Facts of the Case:

Cadbury Schweppes, a British company, had established two subsidiaries (financing companies: Cadbury Schweppes Treasury Services=CSTS & Cadbury Schweppes Treasury International=CSTI) in Ireland, where a lower corporate tax rate (10%) applied to "International Financial Service Centres". The British CFC rules led to the profits of these Irish subsidiaries being taxed in Great Britain as if they had arisen in the United Kingdom. This happened even though the profits were actually earned in Ireland and were also taxed there. However, the losses of the subsidiary CSTS were not taken into account in Great Britain.

Cadbury Schweppes, as the controlling foreign company, argued that the British CFC rules violated the freedom of establishment because they hindered the establishment and operation of subsidiaries in other EU member states, especially in those with more favourable tax conditions.

Ruling of the ECJ:

The ECJ ruled that the British CFC rules indeed constitute a restriction on the freedom of establishment because they could deter companies from establishing subsidiaries in other EU countries. However, such a restriction can be justified if it serves to prevent tax evasion or abuse. Nevertheless, the ECJ clarified that a blanket application of CFC rules is inadmissible. It must be proven on a case-by-case basis that the foreign subsidiary does not carry out any genuine economic activity and merely represents a "wholly artificial arrangement" designed to circumvent tax regulations.

Art. 49 TFEU (ex-Article 43 TEC)

Within the framework of the provisions set out below, restrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State shall be prohibited. Such prohibition shall also apply to restrictions on the setting-up of agencies, branches or subsidiaries by nationals of any Member State established in the territory of any Member State.

Freedom of establishment shall include the right to take up and pursue activities as self-employed persons and to set up and manage undertakings, in particular companies or firms within the meaning of the second paragraph of Article 54, under the conditions laid down for its own nationals by the law of the country where such establishment is effected, subject to the provisions of the Chapter relating to capital.

The ruling demonstrates how the ECJ applies the examination scheme in the area of fundamental freedoms, particularly when assessing the admissibility of national tax regulations.

Scope of Protection of Fundamental Freedoms

The ECJ first examines whether the scope of protection of the fundamental freedoms is affected. In the Cadbury Schweppes case, the scope of protection of the freedom of establishment under Art. 49 TFEU was opened, as it concerned the question of whether a British company may establish subsidiaries in another EU member state (Ireland) and what the tax consequences are. The freedom of capital and services are examined subsidiarily if the freedom of establishment is in the foreground due to a controlling position (control over the subsidiary). The concept of establishment refers to the actual pursuit of an economic activity by means of a fixed establishment in another member state, as set out in Art. 49 Para. 1 TFEU.

Impairment by CFC Taxation

The next step in the examination scheme is to assess whether there is an impairment of the fundamental freedoms. In the Cadbury Schweppes case, such an impairment existed because the British CFC (Controlled Foreign Company) rules led to the profits of the Irish subsidiaries being taxed in Great Britain, even though these profits were earned in Ireland. This constitutes a restriction on the freedom of establishment because it makes the establishment and operation of subsidiaries in low-tax countries unattractive. The comparison with a domestic relocation is flawed because this is not about relocation within one state, but about utilizing advantageous locations within the EU.

Justification and Abuse

The ECJ recognised that such a restriction can in principle be justified if it aims to prevent tax evasion or abuse. However, the ECJ emphasised that a blanket application of the CFC rules is not permissible. It must be specifically proven that the foreign establishment serves as a purely artificial arrangement intended solely to obtain tax advantages. The establishment of a subsidiary in another member state does not justify a general presumption of tax evasion. A blanket regulation that treats every establishment in a low-tax area as abusive is inadmissible. Only the possibility of offsetting advantages, since a lower tax burden exists in Ireland, does not give Great Britain the right to compensate through less favourable tax treatment of the parent company.

Proportionality

The final step in the examination scheme is the proportionality test. The ECJ ruled that measures to prevent abuse are only proportionate if they ensure that the foreign establishment concerned actually carries out economic activities, meaning there is continuous participation in the economic life of the other member state and the actual exercise occurs by means of a fixed establishment for an indefinite period. This means that objectively ascertainable criteria must be met, such as the existence of office space/business premises, personnel, and operating resources (equipment).

These substance requirements must be based on concrete evidence to prove that the establishment is not merely a letterbox company. This is verifiable through the Administrative Assistance Directive.

The German legislator reacted to this ruling by adapting national CFC rules. Initially, this was done through the Jahressteuergesetz 2008 (Annual Tax Act 2008), in which the regulations on CFC taxation were modified to meet the requirements of the ECJ. Within the framework of the ATAD-Umsetzungsgesetz (ATAD-UmsG) (ATAD Implementation Act), this regulation was further tightened (§ 8 Abs. 2 AStG in the current version). These adjustments ensured that CFC taxation in Germany only applies if no actual economic activity exists, and that the substance requirements are checked more strictly to prevent abuse, while simultaneously meeting the requirements of the freedom of establishment.

CFC taxation of the Außensteuergesetz (AStG) (Foreign Tax Act)

§ 8 Para. 2 of the Außensteuergesetz (AStG) regulates CFC taxation, which is applied to the income of foreign subsidiaries if certain conditions are met. This regulation aims to prevent the shifting of income to low-tax countries by attributing the income of so-called "Controlled Foreign Companies" (CFC) to the domestic parent company and taxing it in Germany.

Act on Taxation in Foreign Relations (Foreign Tax Act)

§ 8 Income of intermediate companies

(…) (2) Notwithstanding paragraph 1, a foreign company is not an intermediate company for income for which it is proven that the company pursues a substantial economic activity in the state in which it has its registered office or management. This requires, in particular, the use of the material and human resources necessary for the exercise of the activity in that state. The activity must be carried out independently and responsibly by sufficiently qualified personnel. Only income of the company that is generated by this activity shall be allocated to the substantial economic activity of the company, and only to the extent that the arm's length principle (§ 1) has been observed. Sentences 1 to 3 do not apply if the company has its essential economic activity predominantly performed by third parties.

(3) Paragraph 2 only applies if the foreign company has its registered office or management in a member state of the European Union or a contracting state of the EEA Agreement.

(4) Paragraphs 2 and 3 do not apply if the state in which the company has its registered office or management does not provide information by way of international exchange of information that is necessary for the implementation of taxation.

(5) Low taxation exists if the income determined in accordance with Section 10(3), for which the foreign company is an intermediate company, is subject to a burden of income taxes of less than 15 percent, without this being based on an offset with income from other sources. (…)

Key points of § 8 Para. 2 AStG in the current version:

1. Income Attribution:
   • Income of a foreign subsidiary is attributed to the domestic shareholder if the foreign company is low-taxed and earns certain passive income, such as interest or royalties.
2. Low Taxation:
   • Low-taxed income exists if the tax burden abroad is less than 15% (previously 25%).
3. Economic Activity:
   • An important change introduced in the course of implementing the Anti-Tax Avoidance Directive (ATAD) is the test of whether the foreign company carries out substantial economic activity abroad. Only if no substantial economic activity exists does CFC taxation apply.
4. Substance Requirements:
   • For the assumption of an actual economic activity, objective criteria such as the existence of an actual office, personnel, and operating resources (assets) must be proven.
5. Exceptions:
   • Under certain conditions, CFC taxation can be avoided if it is proven that the foreign subsidiary carries out a substantial economic activity and was not established solely for tax avoidance.

The background of § 8 Abs. 2 AStG is to prevent the abuse of tax benefits through artificial outsourcing of corporate profits (via freedom of establishment) and to ensure that the protection of the member states' taxation interests is maintained. Thus, only substantial and economically active establishments abroad can benefit from tax advantages. This concept was significantly shaped by the ECJ ruling in the Cadbury Schweppes case.

These regulations are a direct reaction to ECJ case law, particularly the ruling in the Cadbury Schweppes case, which clarified that a blanket application of CFC taxation is not permissible and a case-by-case examination must always take place.

The German legislator reacted to this ruling by adapting the national CFC rules. Initially, this was done through the Jahressteuergesetz 2008, in which the regulations on CFC taxation were modified to meet the requirements of the ECJ.

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Note
**This article serves as general information and was carefully prepared by the Lexo.Tax editorial team. Personal tax advice can only be provided within the framework of a membership with Lexo.Tax – and exclusively to the legally permitted extent according to § 4 Nr. 11 StBerG (Tax Consultancy Act).