Until February 21, 2006, when the decision in Halifax plc and others v Commissioners of Customs and Excise1was made, many U.K. tax commentators argued that there wasn’t a concept of “abuse of rights” applying to U.K. tax.

The instinctive reaction of a British lawyer, brought up on the common law, is that a doctrine of abuse of rights is anathema. We understand the principles of individual rights, of governments whose powers are subordinated to those rights, and of an independent judiciary to declare and uphold those rights. That we should be told that we cannot exercise our rights “abusively” is a contradiction in terms.

However in the United Kingdom we do speak of conditional or limited rights. I have a right (liberty) of free speech. If I incite someone to violence I can be indicted. So the right of free speech is not unlimited but is subject to restrictions. If I do incite someone to violence, we would not say that I have abused my right of free speech; merely that I had no right to do so in the first place. This is a matter of the extent of rights, not their abuse; I could only enjoy an unlimited right of free speech if my right takes priority over, for example, the right of someone else not to be defamed.

I. The Concept of Motive in U.K. Tax Avoidance

The classic English case on motive is Bradford Corporation v Pickles,2 especially the comments of Lord Halsbury, the Lord Chancellor LC:

“If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it. Motives and intentions in such a question as is now before your Lordships seem to be absolutely irrelevant”.3

It is clear from many United Kingdom (U.K.) authorities dealing with tax planning or tax avoidance that the motive of the taxpayer is irrelevant. The law was set out in IRC v The Duke of Westminster4 in 1937. As Lord Tomlin said in a famous passage:

“Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax”.5

Although the precise scope of the Duke of Westminster principle is now subject to the doctrine in Ramsay (WT). Ltd v the Inland Revenue Commissioners,6 it was in general approved by Lord Wilberforce in that case. And it is now firmly established that the Ramsay principle itself is simply a rule of statutory construction and cannot be used to undermine rights (or immunities) clearly conferred by a statute or to impose duties which the statute does not impose.

II. The Abuse of Rights Principle in E.U. Law

In E.U. tax law, by contrast to U.K. law, it is now clear that there is a principle of abuse of rights.

Customs relied heavily in the Halifax case (of which more later) on Emsland-Stärke7as laying down a general principle of abuse of rights in EC law.

This case turned on the interpretation of Commission Regulation 2730/79, laying down common detailed rules for the application of the system of export refunds, on agricultural products. The case thus concerned a right granted by EC law.

Emsland-Stärke exported to Switzerland several consignments of a product based on potato starch. On an application by Emsland-Stärke, the HZA (the German Customs Office) granted the company an export refund. Immediately after their release for home use in Switzerland, the exported consignments were transported back to Germany unaltered, and by the same means of transport, under an external community transit procedure and were released for home use on payment of the relevant import duties.

There appears to have been no real argument that abuse of rights was not in point, the main argument being that Germany could no longer claw back the refund. Some U.K. commentators have argued that the real reason that the court found against Emsland is that the regulation gave no right to an export refund if there was no intention to put the goods exported into free circulation outside the EC. While this was perhaps a tenable interpretation at the time that the judgment was released, the authors respectfully submit that it is no longer tenable.

The Court quoted the three-element test suggested by the Commission covering objective, subjective, and procedural law elements; but it then formulated its own:

“A finding of an abuse requires, first, a combination of objective circumstances in which, despite formal observance of the conditions laid down by the Community rules, the purpose of those rules has not been achieved.

It requires, second, a subjective element consisting in the intention to obtain an advantage from the Community rules by creating artificially the conditions laid down for obtaining it. The existence of that subjective element can be established, inter alia, by evidence of collusion between the Community exporter receiving the refunds and the importer of the goods in the non-member country”.8

This judge-made doctrine, which appeared nowhere in the treaties, has also received legislative form in some areas.Regulation 2988/95/EC on the protection of the European Communities’ financial interests, Article 4(3), refers to:

   “the obtaining of an advantage contrary to the objectives of the Community law applicable”.

One should also make mention of Council Directive 2003/49/EC, the interest and royalties directive, which is clearly a political prefiguring of the Court’s recent attitude.

Article 5 (Fraud and abuse) reads:

“1. This Directive shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse.

2. Member States may, in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse, withdraw the benefits of this Directive or refuse to apply this Directive”.

III. The Halifax Case

The case of Halifax9 has placed the abuse of law/abuse of rights doctrine centrally on the stage for taxes governed by European law.

Halifax plc was building four call centres. Had it contracted directly with the builders, it would have incurred a large amount of irrecoverable input tax (Halifax is a bank and therefore limited in its rights of VAT recovery).

Instead, Halifax interposed two subsidiary companies between it and the third party builders and through a combination of carefully timed payments, prepayments and grants of interests in land achieved a situation where, under a literal application of the U.K. VAT legislation, the vast majority of the VAT charged by the builders was recoverable by the subsidiaries. The U.K. tax authorities argued that the structure was ineffective on the basis that transactions motivated by tax avoidance were not supplies for the purposes of VAT and therefore did not give rise to a right to recover input tax.

The taxpayer appealed to the U.K. VAT Tribunal which found in favour of the tax authorities. This decision was later quashed by the High Court and remitted to the Tribunal which made a reference to the ECJ. The reference dealt with two broad issues: firstly whether the existence of a supply could be affected by the motive of the party making it, and secondly whether the doctrine of abuse of rights meant that the taxpayer was not entitled to recover its input tax.

Both the Advocate General and the ECJ swiftly dismissed the first question; whether or not an activity constituted a supply could not be affected by the motivation of the person carrying out that activity. If the activity met the objective criteria for being a supply, i.e., the provision of goods or services in return for consideration, then the fact that it was carried out as part of a structure designed to reduce the taxpayer’s tax burden was irrelevant.

However, according to the Advocate General, “tax law should not become a sort of legal “Wild-West” in which virtually every sort of opportunistic behaviour has to be tolerated so long as it conforms with a strict formalistic interpretation of the relevant tax provisions and the legislature has not expressly taken measures to prevent such behaviour” (paragraph 76).

The Grand Chamber of the ECJ, echoing the Advocate General, held that the principle of prohibiting abusive practices (the principle formerly known as abuse of law) applied to VAT. Although taxpayers are generally entitled to structure their affairs so as to minimise their tax liability (paragraph 73 of the ECJ judgment), this is not the case where there are abusive practices. Abusive practices exist only if:

  • formal application of the conditions laid down by the relevant provisions of the Sixth Directive and the national legislation transposing it result in the accrual of a tax advantage the grant of which would be contrary to the purpose of those provisions; and
  • it is apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage.

Although the ECJ held that it was for the national court to determine whether the conditions were met, this did not prevent it holding that, in the case of Halifax, both conditions were clearly met (thereby rather limiting the role of the national court).

Once the national court has detected an abusive practice, it must redefine the transactions involved so as to “re-establish the situation that would have prevailed in the absence of the transactions constituting that abusive practice” (paragraph 98).

The first condition set out by the ECJ poses philosophical and epistemological issues which will be returned to below. The second raises more practical questions. The ECJ set the bar rather high in stating that “the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages” (paragraph 75). This appears to say that any commercial reason for the transactions in question would be sufficient to prevent there being an abusive practice.

In the case of Emsland-Stärke, this is a fairly easy test to apply. The transactions in question are the export and re-import of the potato starch. Clearly, this served no economic purpose in itself and was done solely in order to generate the entitlement to the export refund. Without the refund, it would not have been necessary to carry out those transactions in a different way; rather, it is inconceivable that they would have been carried out at all.

The case of Halifax is different. Halifax was building call centres to be used for the purposes of its business. The transactions concerned were supplies of construction services. If the transactions complained of by the U.K. tax authorities did not take place, Halifax would have had to find other means to procure the building of its call centres. Regarded at a global level, this appears to be the permissible minimisation of tax liabilities referred to by the ECJ in its judgment. It is only when the analysis is carried out in respect of individual transactions, rather than the overall structure, that the test laid out by the ECJ can possibly be satisfied. This suggests a potentially wide application for the principle of abuse. In most tax planning structures, there will be one or more component steps that would not be carried out, or would be carried out in a different way, were it not for the tax planning.

A forensic approach to identifying the transactions in respect of which one must identify the essential abusive aim may lead to the strict test having a very wide application. It will be interesting to watch how the case law in this area develops.

The ECJ referred to the second test as based on “objective factors”. The reason for this is that in answering the first question, the court had made clear that the motive of taxpayers was irrelevant. However, it is difficult to see in practice how the test can truly be objective. If, objectively, there can be no motive for a transaction other than gaining a tax advantage, it follows that gaining that advantage must also have been the subjective intention of the taxpayer (unless the taxpayer is wholly irrational). Thus, in that case, the subjective and objective coincide. However, the converse is not true. If, objectively, there are “acceptable” reasons for carrying out a transaction, that does not mean that the actual taxpayer’s intention was acceptable; it may have been motivated solely by tax avoidance. The true intention in such a case can only be determined subjectively. The authors wonder whether the intention of the ECJ was to disapply the abuse principle where a taxpayer is able to point to genuine commercial reasons for carrying out the transactions in question that someone else might have, but he did not. In Halifax, the point had been conceded by the taxpayer before the Tribunal; in other cases, it may well be that a degree of subjectivity will creep back into the test.

The authors now return to the philosophical issues raised by the first test. As is frequently the case with decisions of the European Court, the judgment is somewhat laconic and the intellectual underpinning is to be found in the Opinion of the Advocate General.

A key point made by the Advocate General is that the principle is one of interpretation. Therefore, it does not need to be enacted either in Community legislation or in the legislation of Member States. Member States, including their courts, are obliged to apply the principle of prohibiting abusive practices in interpreting both Community law and national law that implements Community law.

In essence, this means that there is a principle of interpretation that may require the clear words of a law to be taken to mean their exact opposite (although Halifax is perhaps more complicated, the position in Emsland-Stärke is stark). The Advocate General does not shy away from this conclusion. He stated at paragraph 71 that:

“one must conclude that a person who relies upon the literal meaning of a Community law provision to claim a right that runs counter to its purposes does not deserve to have that right upheld. In such circumstances, the legal provision at issue must be interpreted, contrary to its literal meaning, as actually not conferring the right”

and at paragraph 79 that:

“If this interpretation entails any kind of derogation, it will be only from the text of the rule, not from the rule itself, which comprises more than its literal element” [emphasis added]

The concept of a law having a richer existence outside of, and apparently inconsistent with, the statute that created it (and presumably unknowable in its fullness by mere humans) is one that would have been familiar to Plato.10 Plato believed that objects in the real world were pale copies of archetypal forms; we can recognise a variety of animals as dogs because they all possess attributes of the form “dog”. The metaphysical form is the epitome of beauty and perfection. Objects in the physical world bear the same relation to their form as shadows dancing on the wall of a cave to the objects outside casting the shadow.

This is a philosophical theory that has few supporters today. What does it mean to have a perfect form that cannot be perceived by humans? How can forms interact with the material world if limited to an existence on the metaphysical plane? Similar questions apply in relation to the rules identified by the Advocate General. Where is the abstract rule and how are we to know and apply it? How is this a helpful aid to legal construction?

There is also the question of the application of this decision in the courts of the Member States. It is one thing to apply the specific decision of the ECJ in Halifax, it is another to apply the test in other cases without a clear and specific direction from the ECJ. It is hard to imagine an English Chancery court judge having much sympathy with the submission that clear words in a statute should be ignored in favour of contrary words to be deduced from the statute’s metaphysical parent.

Leaving aside the esoteric realm and returning to practical matters, it is likely that tax authorities will be seeking to rely on the concept of abuse as both sword and shield (i.e., to attack what they perceive as unacceptable tax planning and to deter such things from happening). For taxpayers, it is advisable to make a contemporaneous written record of the commercial reasons for each transaction that involves some tax structuring, which can be used to demonstrate this to the tax authorities in any future negotiations or dispute.

It may also be worth documenting possible alternative methods of undertaking the transaction in question which it is thought would be less vulnerable to challenge (and would be the next best alternative tax efficient outcome for the taxpayer). Although the courts in each Member State can apply the ECJ guidance in Halifax and re-characterise as they see fit, given that this would be a contemporaneous record, it should carry some weight with the court and may assist the taxpayer in arguing for its preferred re-characterisation.

IV. The Cadbury Schweppes Case

Like a number of other E.U. countries, the United Kingdom has implemented CFC legislation. The CFC legislation is designed to tax a U.K. resident parent company on undistributed profits of subsidiaries resident in “lower tax” jurisdictions. A jurisdiction is a lower tax jurisdiction if its tax rate is less than 75 percent of the U.K.’s tax rate. There are a number of exemptions from the CFC legislation including a distribution of profits exemption, a trading exemption, and the motive test.

Cadbury Schweppes Plc is incorporated and resident in the United Kingdom. It is the parent company of a group of companies including two indirect 100 percent subsidiaries incorporated with unlimited liability in Ireland and agreed (for the purposes of this case only) to be resident in Ireland, Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI). CSTS and CSTI were subject to a tax rate of 10 percent within the International Financial Services Centre in Dublin. CSTS and CSTI raised finance and provided that finance to subsidiaries in the PLC worldwide group. HM Revenue & Customs (“HMRC”) sought to apply the CFC legislation to the profits of these companies.

Cadbury appealed to the Special Commissioners who referred the case to the ECJ in the following terms:

“Do Articles 43, 49 and 56 of the EC Treaty preclude national tax legislation which provides, in specified circumstances, for the imposition of a charge upon a company resident in that Member State in respect of the profits of a subsidiary company resident in another Member State and subject to a lower level of taxation?”11

In the Cadbury Schweppes case (as in the ACT IV,12 FII,13 and Thin Cap14 GLOs) HMRC argued the abuse of rights principle before the ECJ. The decision in Cadbury Schweppes15 was delivered on September 12, 2006.

In their decision the ECJ addressed the abuse of rights point first. The Court concluded that while Treaty rights must not be used to circumvent legislation or facilitate fraud, if a legal person establishes itself in a Member State to take advantage of lower taxes, that does not of itself constitute abuse.

The carve-out allowing for CFC rules in the case of “wholly artificial arrangements” imposed a very high threshold for abuse before CFC rules could apply. The establishment would have to be fictitious; it would have to carry on no genuine economic activity16 in particular, it would have to be akin to a letterbox or front company. If it had premises, staff and equipment, it would have genuine economic substance. It is also important that the Court commented that, just because the economic activity could just as well be carried on in the home state, that does not mean that the overseas operation is artificial.17

The reasons which motivated a company in question to locate itself in a more tax advantageous environment cannot affect the conclusion of whether it has genuine economic substance or not. The judgment makes reference to the settled case law under which a Member State may not restrict the right of a company to exercise the freedom of establishment for fiscal reasons.18 The fact that none of the exceptions apply and that the intention is to obtain tax relief is still not sufficient to conclude that a company is a wholly artificial arrangement.19

How do you test the legislation if a company does not come within the exemptions and a charge under the U.K. legislation in principle applies? The ECJ seems to be saying if a company is not within an exemption, but is nevertheless exercising its E.U. freedoms, the legislation falls to be disapplied.

V. Conclusions

In the past, tax law, in the United Kingdom at least, did have some resemblance to the legal Wild West identified by the Advocate General in Halifax. The courts took a strict interpretation of the law and were morally neutral as to tax planning.

However, the Wild West has been in the process of being tamed for many years now. The U.K. courts have taken a far more purposive view of legislative interpretation and, unsurprisingly, tend to find that Parliament did not intend the laws to be circumscribed by eagle-eyed professional advisers spotting loopholes.

This trait is even more pronounced in VAT and other tax cases where European law is relevant. In the past, the accepted view of both practitioners and courts was that the taxpayer could rely on U.K. law if it failed properly to implement European directives. This is no longer the case; the courts have shown themselves increasingly ready to read words into U.K. statutes to meet the requirements of European law (see IDT Card Services Ltd v HM Commissioners of Revenue & Customs20). Part of this development can be traced to the implementation of the ECHR into U.K. law and the strong purposive construction required by the Human Rights Act which the House of Lords has said is the same test as applies to construing domestic law in light of EC law requirements.

At one level, the principle of abuse of law is simply a further example of this. However, it goes significantly further in elevating purpose above construction. Where there is an abuse, it does not matter what the law says; the courts are obliged to enforce what it ought to have said. This is a new proposition and a somewhat worrying one, at least for a common law practitioner.

Legislation that is badly written can now be rescued by the courts. One hopes that this does not lead to more bad legislation, with the need for the executive and legislature to check and consider the consequences reduced by the comfort blanket of the principle of abuse of law thrown by the courts.

But this is not going so far as to say that legislation that is incompatible with European law (i.e., that can’t be read in a compatible way) can be rescued by the courts. Such legislation will fall to be disapplied. The Cadbury Schweppes judgment shows that the ECJ regards some elements of European law as so important as effectively not to be capable of being abused. In other words, some of the written laws (such as freedom of establishment) are of such fundamental importance that they eclipse the unseen and different but perfect metaphysical forms of the law.

The stream of cases that are sure to follow over the coming years will help to show whether abuse of rights has a broad application as in Halifax or a limited application as in Cadbury Schweppes. However the law develops, it is clear that the best defence to an attack on the basis of abuse of law will be the ability to demonstrate a genuine commercial purpose for one’s actions. Taxpayers will be well advised to bear this in mind when deciding how to structure their affairs.

1     Halifax plc and others v Commissioners of Customs and Excise, (Case C-255/02); [2006] STC 919

2     Bradford Corporation v Pickles [1895] AC 587

3     Ibid at 594

4     IRC v The Duke of Westminster [1936] AC 1

5     Ibid at 19

6     W. T. Ramsay Ltd. v. Inland Revenue Commissioners, Eilbeck (Inspector of Taxes) v. Rawling [1982] A.C. 300.

7     Emsland-Stärke v Hauptzollant Hamburg-Jonas (Case C-110/99)

8     Ibid at paras 52 & 53

9     Halifax plc and others v Commissioners of Customs and Excise, (Case C-255/02); [2006] STC 919

10  And probably also to Josef K, the protagonist of Kafka’s The Trial, in his frenzied and unsuccessful attempt to determine the nature of the laws under which he was accused.

11  Special Commissioners, Reference of June 6, 2004

12  Test Claimants in Class IV of the ACT Group Litigation (Pirelli, Essilor and Sony); Test Claimants in Class IV of the ACT Group Litigation (BMW) v Commissioners of Inland Revenue (Case C-374/04)

13  Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue (Case C-446/04)

14  Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland Revenue (Case C-524/04)

15  Cadbury Schweppes plc v Commissioners of Inland Revenue (Case C-196/04)

16  Ibid at para 68

17  HMRC has seized on this “economic activity” concept in designing the new “net economic value” CFC test announced in the Pre- Budget Report on December 6, 2006. This article does not aim to address the new rules but time will tell whether HMRC have got hold of the right end of the stick.

18  Eurowings Luftverkehrs AG v Finanzamt Dortmund-Unna, (C-294/97)

19  Cadbury Schweppes plc v Commissioners of Inland Revenue (Case C-196/04) at para 63

20  The Commissioners for Her Majesty's Revenue and Customs (formerly known as the Commissioners for Customs and Excise) v   IDT Card Services Ireland Ltd  [2006] EWCA Civ 29

This article was originally published in the December 2006 edition of Tax Planning International  Review. Republished with permission.